Did you know that a majority of your “conscious” decisions are really driven by subconscious biases?
That you’re more likely to invest in a certain stock when your friends or prominent investors tell you that they’re going to do so?
That when you invest in a certain stock and it does well, you consider yourself an investing genius. But when that same stock plummets, you blame the economy?
These are all traits found in human behavior that form the basis of the relatively new field of study that is behavioral finance. The foundation of behavioral finance is that people make irrational decisions—based on faulty biases and heuristics—when it comes to their money.
So in honor of Financial Literacy Month, we resurface why it’s so important for you to keep up to date with your financial education.
Fun fact: On March 9, 2004, Senate Resolution 316 passed, designating April as “Financial Literacy Month.” Senator Daniel Akaka [HI] sponsored the bill, which resolved to raise public awareness about the importance of financial education in the United States and the serious consequences associated with a lack of understanding about personal finances.
Losses Vs. Gains
It can come down to the flip of a coin. Imagine: Your friend offers you $50 right now. Or, you could get $100 based on if you choose heads or tails. More often that not, you’re going to opt for the free-and-clear $50. It’s a sure thing.
Or flip the scenario. Would you take a sure loss of $50 or, based on the flip of a coin, lose $100 or nothing? You would probably flip the coin as there’s a chance that you won’t lose anything.
This is known as loss aversion.
“The chance of the coin landing on one side or the other is equivalent in any scenario, yet people will go for the coin toss to save themselves from a $50 loss even though the coin flip could mean an even greater loss of $100,” says veteran finance adviser Ben McClure in a recent Investopedia article. “That's because people tend to view the possibility of recouping a loss as more important than the possibility of greater gain.”
So when faced with potentially losing something that may not be as large of a loss as you perceive, how is that impacting your finances?
Herd Instinct
We are social creatures. We get anxious or uncomfortable when we make decisions that are contrary to the status quo.
Imagine: You are watching the news and there’s a hot new tech company whose stock is soaring. Prominent investors are pouring their money and their clients’ funds into purchasing these stocks to get in on the ground floor. All of these people can’t be wrong, right? They’ve done their research or they know something we don’t. You feel a strong desire to buy, buy, buy!
“What has happened is that people have ignored their information,” writes certified investment adviser Rashmeet Kaur in a 2020 Finology blog. “And that creates a distorted signal chain. We think that everyone has made an informed decision, and that decision appears to have value. But in reality, everyone's decision is based on the decisions made by others. And because of this, our decisions contain no real valuable information.”
So maybe that new stock investment isn’t right for your financial well-being.
These are just two examples of the many faulty biases and heuristics that we deal with on a daily basis. So it’s important to understand behavioral finance so that you can make well-informed decisions to keep your finances healthy.
Why You Should Understand Behavioral Finance and Economics—As Told by Behavioral Finance Instructor Richard Lehman
Behavioral science holds significant implications for many aspects of society—journalism, law, health care and technology, to name a few—as well as in the choices we make throughout everyday life such as where we live or work, and whom we vote for, hire or even partner with.
But the area of greatest initial focus has been in finance and economics. The new decision paradigm reveals critical insights about the way people spend, save and invest. This causes many to question the assumptions behind decades-old financial theories that form the pillars of our financial system.
A great deal of research has been conducted during the past 40 years toward finding out how behavioral science affects financial decisions among both individual investors and industry professionals, and in turn how it affects the financial markets themselves.
Because financial decisions can often be quantified and outcomes measured, the results have been able to identify not only the numerous ways in which people deviate from rational economics, but the magnitude of the effect on their investment performance. The impact of this research for the financial industry has been to make behavioral education a required part of advanced financial degrees and professional certifications like CFP® and CFA®.
We offer an overview course in Behavioral Finance that is now in its 11th year. Open to anyone interested, and with no prerequisites or degree requirements, the course has received wide acclaim from Berkeley students, many of whom say that it has been the most impactful financial course they have ever taken. The Bay Area Financial Planning Association recommended we make the course required for those completing the Personal Financial Planning certificate.
So any individual can take advantage of the same course as career financial planners. The course does not require a specific educational background in either psychology or financial theory, and is as valuable for individuals who manage their own finances and investments as it is for certified financial planners. While many U.S. universities now offer courses in Behavioral Finance, very few offer an online option and make their courses openly available to the public.
Save your seat!
Richard Lehman, M.B.A., is the author of Options for Volatile Markets: Managing Volatility and Protecting Against Catastrophic Risk (Bloomberg, 2011). He has a Wall Street and financial industry background spanning 34 years, and he is the founder of RHL Capital, LLC.