Thursday, August 16, 2018

Behavioral Finance

 

 

“We are made wise not by the recollection of our past, but by the responsibility for our future.” George Bernard Shaw

Emotions can overrule intellect and may interfere with sound thinking. For instance, after watching a particularly gruesome crime show on television, I took our dogs out for their nightly walk. Because of the TV show, illogical fears popped into my head warning me of unfounded danger behind every palm tree.

It is a scientific fact that we respond strongly to recent information. Suppose you’ve just watched “Shark Week” on The Discovery Channel. You may avoid swimming in the ocean even though the odds are only 1 in 11.5 million that you’ll be attacked by a shark in the United States.

B20_1These are examples of the “availability bias” concept which is a fancy way of saying that recent and vivid images tend to stand out. The brain references whatever information is freshly burned into your mind, rational or not. Availability bias applies to investors as well. Just recall the last news story or advertisement you heard on your favorite financial news network and think about how that may have influenced your decision-making.

We’re Only Human

The field of behavioral finance examines psychological variables as they relate to investing. The facts are that emotions and assumptions influence investor decisions. Recognizing and respecting these facts may help make us better long-term investors.

For investors, not much has been more dramatic than the 2008 financial crisis. We know that dramatic, relevant, and recent experiences influence our thoughts and actions. It’s also true that the pain of a loss is much stronger than the reward of a gain. In fact, the desire to avoid market losses has caused many investors to move their money out of stocks.

Yet this perceived safety may come at a cost; that cost is the erosion of purchasing power due to inflation. The U.S. Bureau of Labor Statistics defines inflation as year-over-year changes of the Consumer Price Index* and reports the 30-year average rate of inflation at 2.91%. A quick trip to the grocery store provides a great lesson on how inflation diminishes the value of your money and affects spending habits.

Current events influence our decisions. The first two months of this year have already proven to be eventful for investors and the financial markets. For starters, on January 2, 2013 we avoided the financial cliff with the passage of the American Taxpayer Relief Act (ATRA), a significant piece of legislation, which extends some tax cuts and reassesses taxes on upper income households. ATRA also put in place temporary tax breaks for businesses, extended unemployment benefits for 2 million people and postponed automatic spending cuts, known as the sequester, until March. Another provision eliminated the temporary cut to

 

 

Social Security payroll taxes, which increased them from 4.2% to 6.2%.

The ATRA, however, failed to address the debt ceiling, and Congress just passed a debt limit measure that would allow additional borrowing until mid-May.

We also learned that for the first time since the 2007-2008 recession began, the Commerce Department reported that gross domestic product (GDP*) shrank during the fourth quarter, falling 0.1% compared to an expected 1.1% gain. Reports that the economy added 192,000 private sector jobs in January and that single-family home prices rose helped to balance out that disappointing GDP report. In addition, on a more positive note, the corporate earnings season started out strong, boosting investor interest in stocks. Has this information affected your financial decision making, and if so, in what way?

Make sure your expectations for a return on your money are both realistic and sufficient to give you the best chance of achieving your goals and keeping pace with inflation. Remember, an investment’s past performance is no guarantee of its future results. Understand what you own and what role each investment fills in our portfolio. Though diversification cannot guarantee a profit or eliminate potential loss, it can help you manage the types and level of risk you take. Consider adjusting asset allocations to coincide with your life circumstances and have a game plan to keep you from panicking during volatile markets.

Long-term wealth building requires patience and the ability to separate noise from news. At times, it can be difficult to remain unemotional, but try to avoid self-destructive behavior by controlling feelings and sticking to your personal and customized investment plan. Stay focused and invest accordingly.

*The Consumer Price Index (CPI) is a measure of the average change in consumer prices over time of goods and service purchased by households; it is determined monthly by the U.S. Bureau of Labor Statistics. Investors cannot invest directly in an index. Gross Domestic Product (GDP) is the annual total market value of all final goods and services produced domestically by the U.S.

This information is general in nature, it is not a complete statement of all information necessary for making an investment decision, and is not a recommendation or solicitation to buy or sell any particular investment. Investing involves risk and the possible loss of principal invested. Investing involves risk, and investors may incur a profit or a loss. There is no guarantee any particular investment strategy will be successful. Opinions expressed herein are those of the author and subject to change at any time.

Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™ and federally registered CFP (with flame logo), which it awards to individuals who successfully complete initial and ongoing certification requirements. Diversification and strategic asset allocation do not ensure a profit or protect against a loss.

 

Leave a Reply

Your email address will not be published. Required fields are marked *