Investing and financial planning can all be about numbers, so it’s easy to see why economists long assumed people approach these subjects logically. Researchers have found abundant evidence that people often are more irrational about finances, investing and reading markets than previously known. Understanding how biased and oversimplified thinking can influence perspective can be fascinating and very useful to investors, which is where behavioral economics comes into play. If you need more insight, consider finding a financial advisor to help you design a smart investing approach that fits your goals.
Behavioral Economics: The Basics
Behavioral economics has a very interesting history despite being just a few decades old. In the 1970s and 1980s, a few economists, notably Richard Thaler of the University of Chicago, questioned a basic premise of economic theory. This was the idea that humans are rational investors and observers, and that their rationality directly influenced how markets behaved. But Thaler and other experts, like economist Gary Becker and psychologist Daniel Kahneman, weren’t just theorizing. They produced many studies that indicated humans often do not buy, sell and invest in ways that maximize positive outcomes. And sometimes, their actions run directly against their interests.
By the 1990s, this research had coalesced into a discipline, which we now refer to as behavioral economics. For shorthand purposes, you can think of it as a blend of psychology, decision-making theory and economics. It explores cognitive bias, anecdotal experience, plain old emotion and their effects on the collective activity of markets.
Behavioral finance is a term often used interchangeably with behavioral economics. The distinctions between them aren’t absolute at this point. But some experts treat behavioral finance as a sub-category of behavioral economics, which concerns many types of actions, not just those tied to money and economics. That said, if you’re discussing how humans interact with just about anything of value, the term behavioral economics will suffice.
Behavioral economics has become widely accepted and influential among academics and financial professionals. Currently, the research is expanding our insights into decision-making in fast-paced environments. This is a still-evolving discipline, but to sum up its prevailing wisdom, bias and oversimplification affect the behavior of individuals and markets in many ways.
The Main Themes of Behavioral Economics
One of the major themes of behavioral economics is bias. In can manifest in several ways:
- Overconfidence (in skills, knowledge base, talent, intelligence)
- Self-attribution (thinking that great returns are a result of our skills and insights, while we chalk up bad returns to bad luck)
- Confirmation bias (looking for facts or occurrences that support an existing belief)
- Framing bias (basing a decision on how something is presented, rather than actual fact)
Oversimplification is another important factor. It’s not entirely irrational, either. The world is enormously complex, and humans must simplify many events and ideas to make sense of them. For investors, however, this can lead to overemphasizing the performance of a single asset or perceiving a trend in a too-small sample size of stocks.
Bias and oversimplification don’t just affect individual investors. Behavioral economists argue the stock market can swing up or down due to a sort of mass irrationality. Risk aversion-another psychological trait-can influence the market to the point of panic. Richard Thaler argued that the market crash of 1987 occurred at a time when ‘nothing was happening, but investors thought otherwise and a massive sell-off ensued.
In a less dramatic example, the value of an individual stock may be wildly inflated or deflated because the rational analysis isn’t driving the market’s assessment.
Why Behavioral Economics Is Relevant to Investors
It’s not necessary for average investors to be experts. However, there are a few principles of behavioral economics that can create effective checks on our impulses and biases.
First, it helps to recognize any investor can act irrationally. During panics like the Great Recession in 2008, many will violate one of the fundamental rules of investing- buy low, sell high- based on fear rather than analysis. Conversely, some investments look great because they have emotional appeal, thanks to a charismatic leader or a seemingly great idea. This can breed investor overconfidence and obscure signs of inflated value. Although it never made it to the public offering stage, the story of Theranos is a good example of this phenomenon.
Some familiarity with behavioral economics can help investors assess their own tendencies. Armed with extra awareness, they can challenge their assumptions by reading contrary opinions. They can consult with an advisor who can take a more pragmatic view of investment opportunities. In short, investors can make a decision to accept the existence of irrational tendencies and, hopefully, correct them.
How Behavioral Economics Can Explain Market Activity
Businesses of all sizes now incorporate many of the core principles of behavioral economics in their marketing strategies. Financial institutions are using new research in the field to better predict market and investor behavior. However, since machines and algorithms do a great deal of trading these days, some market analysts argue that the investing world is becoming more predictable and self-correcting.
But since humans build computers and algorithms, a counterargument suggests our cognitive biases may still influence the systems we create. There now are complex trading strategies that assume confirmation bias, overconfidence and oversimplification affect investor behavior. Even professional investors, faced with massive amounts of information, can take mental shortcuts.
They may unconsciously depend on the bias to make decisions. The logical analysis takes time and effort, while today’s financial markets move at lightning speed. It’s possible that in some cases, there isn’t time enough to think slowly and methodically.
Whether funding a retirement account or picking winners and losers in the stock market, investors can use behavioral economics ideas to challenge their thinking. It doesn’t mean traditional economic theory no longer applies. Instead, behavioral economics suggests there is another factor to consider when we read earnings reports and keep tabs on companies we invest in. And it presents a strong argument that anyone, from the wealthiest investor to the beginner, should seek outside verification for their hunches.
The Bottom Line
Behavioral economics can add an extra dimension to your investment strategy. It may provide one of the best reasons for working with a financial advisor, since ideally, this kind of professional will challenge your instincts and preferences. Some investors may prefer using established economic thinking and advice, and certainly, there is nothing wrong with that approach. That said, it helps to recognize that many investors and institutions now accept behavioral economics and incorporate it into their decision-making.
Tips For Investing
- Many financial professionals make it their business to understand how their clients think about money and investing and know when to challenge them. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Whether you’re eager to study behavioral economics or not, it can help to assess what kind of investor you are. One of the most important places to start is to determine your risk tolerance.
Photo credit: ©iStock.com/Weekend Images Inc., ©iStock.com/BartekSzewczyk, ©iStock.com/fizkes