Money Matters

The Nature of Human Behavior: Behavioral Finance

19 Dec 2018 by: Matt Showley 

Humans are hard wired to avoid pain and discomfort. The ability to adapt and evolve to avoid these feelings has kept humans alive and progressing throughout history. This is also why investing in the markets during such a volatile time can be so emotional. The drop in value of a portfolio inherently triggers an investor’s emotions and can lead to emotional decisions if not held in check. As financial advisors, we do our best to serve our clients and give our perspective as an objective party to help ease emotions during a stressful time.

The study of behavioral finance may help you (as an investor) learn how you think about your portfolio. As you consume media reports about the recent volatility in the market, remember that there have been volatile times in the market before. As advisors, we are aware of the fact that clients see and feel market turbulence. One behavioral finance term that is relevant when the market moves lower is called the “loss aversion bias.”

Loss aversion bias means investors prefer to avoid losses more than they enjoy gains. Put another way: most people would rather not lose $100 than gain $100. The loss aversion bias can lead investors into making decisions based on emotions rather than a rational process if they see that their portfolio values may be headed in the wrong direction. This bias can partially be traced back to the fact that as humans, we do not like to pain or discomfort. If an investor wants to react to a drop in their portfolio, it is at that point when they need to take a step back and evaluate whether the reaction is an emotional one or part of their long-term strategic investment plan.

After the market advances we have seen over the past 9 years since the Great Recession of 2008 and 2009, investors may also have a “recency bias.” A recency bias means that investors are focused on recent events and have a difficult time remembering the past events. Over the last 9 years the general trend for the U.S. stock market has moved in an upward direction. That upward trend was recently interrupted, and investors may underestimate the probability of a market correction because in recent years the trend has been that the market continues to move higher. Conversely, if investors focus on the recent declines, they may forget how well the market has done in the years prior.  In reality, markets tend to move in cycles rather than follow a linear path.

Why do investors react this way? Why does the market tend to act negatively towards uncertainty? Based on behavioral finance, we know that humans have evolved over time to avoid pain and discomfort for survival.  This evolution translates into a natural “fight or flight” response to a variety of events. Investors see negative numbers and want to take-action to avoid them. In turn, these knee jerk reactions lead to emotional decisions which, over time, tend to hurt the long-term performance of a portfolio. Something new happens in the market every day. If you ever have the feeling that you are uncertain what the outcome of the market will be, then you would be right to feel that way. No one can forecast the future and crystal balls don’t work. This uncertainty is what drives fear for investors, but in the end, investors should realize that the market expands and contracts in a cyclical manner. Over the long-term, CCMI believes the market will continue to move in an upward direction, but intermittently investors should expect periods of ups and downs with increased volatility.

If you have experienced these fight or flight responses when looking at your portfolio or seeing the news headlines, you are not alone.  Please reach out to CCMI’s advisors with questions and concerns so we can talk about your portfolio and cash needs in the frame of a long-term time perspective.

CCMI provides personalized fee-only financial planning and investment management services to business owners, professionals, individuals and families in San Diego and throughout the country. CCMI has a team of CERTIFIED FINANCIAL PLANNERTM professionals who act as fiduciaries, which means our clients’ interests always come first.
How can we help you?

Matt Showley is a CERTIFIED FINANCIAL PLANNER™ professional and Accredited Estate Planner®️ who advises individuals, families, and business owners on portfolio management, financial planning, tax and estate planning, real estate, cash-flow modeling, and education planning. In addition to his role as principal and owner, Matt continues to oversee the firm’s operations and work with new and existing clients. Matt joined CCMI in 2006 and has contributed significantly to the firm’s wealth management and financial planning processes and client relationships.

More by this Author
Below are additional articles written by this author.

As you embrace retirement, crafting an estate plan is pivotal to protect your legacy, assets, and loved ones’ futures. An estate plan is essential to…

If retirement is on the horizon within five years, now is the time to revisit your retirement plan and ensure you’re on track. This period…

When considering changing financial advisors, several factors come into play. You may know someone contemplating this transition, whether prompted by a firm acquisition, shifts in…