Ask the Advisor: Behavioral Finance 101

Question: I keep hearing and seeing the term 'Behavioral Finance.' What is it and how may I benefit from it?

Behavioral Finance is just what one might guess: It is a broad term that encompasses the psychology of money.

As you may already know from personal observation, knowledge of financial matters does not always translate to good judgment regarding financial matters. In fact with regard to investing, I tell my clients and prospective clients that even the best investments, when combined with poor investing behavior, will often result in lower returns than an average investment combined with good investing behavior.

Buying high and selling low, for example, are behavioral--not financial--problems. Emotions and money do not make good companions, which is a primary reason the financial planning profession exists today.

Know Thyself

Here are some basics of behavioral finance:

• Your Money & Your Brain: Knowledge of personal finance can help in yielding financial success but the greatest knowledge is self-knowledge. The human brain, for example, is hard-wired for pattern recognition. If XYZ stock price generally rises for two consecutive years, your brain may tell you to bet the farm it will rise a third year. This pattern, however, has nothing to do with fundamental reasoning (i.e.; the financial health of the underlying company).


• Confirmation Bias: People don't like to be wrong so they tend to seek information that proves them right. For example, your pre-conceived bias in regard to the US economy is that we are headed for a double-dip recession; therefore you choose to keep all of your life savings in a money market account earning 0.20 percent, rather than risk investing in a diversified portfolio of stocks and bonds. Because of this bias, you only pay attention to information that agrees with your pessimistic views and ignore information that disagrees with these views.


• Childhood Experience: From a child, you've adopted certain psychological behaviors, knowingly or not, that shape your financial behaviors. For example, if your parents were always telling you, "We can't afford to buy that," when you became an adult you may perceive money as being scarce. No matter how much money you save or how little you spend, you never have "enough." You may also have certain views, such as "all rich people are evil" or "I don't deserve to have money."

Behavioral finance, in my humble opinion, should be required curriculum in school. Self-knowledge is more powerful than financial knowledge.

Kent Thune is a Certified Financial Planner™ and owner of an independent, "fee-only" investment management firm in Mount Pleasant, SC. Kent is also a freelance writer. To read more of his work or to find out how to contact Kent, please visit his blog at The Financial Philosopher. Have a question? Email AsktheAdvisor@savings.com.

_{Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment} ^{advice. Under no circumstances does this information represent a recommendation to buy or sell securities.}