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Making Sense of Behavioral Finance

Behavioral finance’s basic premise is that investors are considered normal, not rational. Normal in the sense that they are occasionally irrational beings prone to making mistakes and investment decisions based on emotions, biases, self-deception and lack of discipline.

At Hefren-Tillotson, we remove the guesswork and utilize our proven successful strategies formulated through nearly seven decades of planning and investing experience. Our financial advisors and planners provide personalized investment recommendations and meticulous wealth management matched to your individual financial situation and goals.

Rules of Thumb and Behavioral Heuristics

Psychologists say most people engage with the world through two systems: the Automatic – the faster, intuitive, instinctual and immediate; and the Reflective – the slower, rational, and deliberative. An example of the Reflective system is when choosing the risk allocation for your 401(k). Instead of doing what your gut or intuition tells you to do, you rely on your research and levelheaded thinking. This works well when collaborating with your advisor.

One main theme of behavioral finance is rules of thumb, pioneered by psychologists Daniel Kahneman and Amos Tversky. They believe we all make decisions based on rules of thumb and not entirely by rational analysis. For example, if the stock market is booming, we might want to rush right in to invest, forgetting that the market is prone to fluctuation. Obviously, your advisor can guide you to making better choices.

These rules of thumb are known as heuristics, and are part of the Automatic system that can adversely affect investor decisions. Mostly, they are mental shortcuts we use when making decisions. We all use them because they are efficient handlers of the daily information overload. The potential danger is when do-it-yourselfers allow their mental shortcuts to be applied to their financial planning.

Taking shortcuts instead of researching and considering all possible outcomes prior to making decisions will not serve you well. Your Hefren-Tillotson advisor plays a key role in full preparation and in your being fully informed and in control of your decision-making.

Equities Do Well … People Don’t

When comparing invest-MENT returns to invest-OR returns, generally speaking, mutual fund investors do better with equities than they do with themselves. Some say it is investor impatience. For example, today, the average period investors hold a mutual fund is three years or less. Going way back to the 1950s, it was 15 years. Information was scarce back then when all they had was The Wall Street Journal or they called their broker.

Today, with many more sources there is additional stress placed on investors’ getting it right. Granted, the financial universe is much larger, but thinking back, investors and brokers could have occasionally been wrong back in the ‘50s and not even known it. In fact, forecasting was hit-and-miss. No one could have forecasted a buy-and-hold strategy of investing $1,000 (a lot of money back then) into a Templeton Growth Fund in 1954 and holding on to it long enough to generate $100,000 even by 1993! Somebody got it right. And once again, this is an example of how building a portfolio for the long-term and sticking to it raises the potential for reward later on.

The media often discourages long-term thinking when they run headlines like, “Stocks You Should Buy Today,” along with other blatant “self-help” attempts to key in on America’s thirst for instant gratification. High-net-worth and other educated investors typically do not fall for the hype because they know better and they consider the source.

At Hefren-Tillotson, we encourage patience. We focus our clients’ attention on forward progress to reaching their long-term goals, not comparisons to market benchmarks like the Dow or S&P 500. Benchmarks are rarely relevant to long-term goals.

Buying High, Selling Low? That’s Not Right

Benchmarks focus on “winners” and “losers.” People will want to get rid of their losers and hold on to their winners, a perfect example of buying high and selling low. This is typical of how the psychology or mentality of the day can work against unsuspecting investors. It causes them to panic, make costly irrational mistakes, and do it at the wrong time. Advisors educate their clients to know that once they succumb to unplanned short-term temptation, their plans to save for retirement or make healthier lifestyle choices often fail.

One client’s asset allocation gave him absolutely no cause for panic. With nearly $3 million in equities, he became fearful and decided to move everything to fixed income at exactly the wrong time: at the bottom of the market. This is your typical aversion to loss, a facet of behavioral finance. Investors are so afraid of losses they focus more on trying to avoid a loss more than making gains.

Generally, investors feel the pain of a loss more than twice as strongly as they feel the enjoyment of making a profit. Aversion to loss might explain why people value the same item more highly when they already own it than the value placed on it if they didn’t  – a phenomenon called the “endowment effect.” Of course, outdated thinking often gets the best of investors too, which is why Hefren-Tillotson advisors focus squarely on education.

Some advisors say their advice means more to clients today than it ever has. And while the “herd” still tries to influence them, more clients take our advice more readily than they did during the roaring bull market. Herd mentality is another facet of behavioral finance referring to “following the herd,” while blindly following the flock.

But, humans make errors and errors can be costly. We understand that. We minimize these common errors by employing a disciplined, long-term approach that underscores prudent diversification, objective selection of individual investments or investment managers, and sensitivity to both risk and costs. If you would like help building a reliable path to achieving your long-term goals, contact us today. We would be glad to help.

DISCLAIMER: Past performance does not predict future results. This report is based on data obtained from sources we believe to be reliable. Hefren-Tillotson does not, nor any other party, guarantee the accuracy or completeness of this report or make any warranties regarding results obtained from its usage. All opinions and estimates included in this report constitute the firms judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation to buy or sell the securities herein mentioned.

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