Behavioral finance uses psychological and social factors to study how people make economic decisions. It was once thought that human beings will over time take the most logical, rational approach when tackling problems. As you might imagine, this is not always the case. In this paper, we address three common issues that affect amateur and professional investors alike and explain different ways these issues manifest themselves in everyday life. We also offer some advice on how to mitigate the negative outcomes when the mind plays tricks on you. Being self-aware of these factors is a critical first step.

1. How Your Mind Plays Tricks on You
Lessons From Behavioral Finance
By Baird Private Wealth Management
There is no doubt that the global economy is experiencing heightened
volatility and uncertainty. How we make decisions in the face of
uncertainty can have long-lasting implications, especially those choices
heavily influenced by emotion. This is true for many decisions made in
life, but our focus is to address how biases and emotions impact financial
decision-making. For that we explore the field of behavioral finance.
Behavioral finance uses psychological and social factors to study how
people make economic decisions. It was once thought that human beings
will over time take the most logical, rational approach when tackling
problems. As you might imagine, this is not always the case. In this paper,
we address three common issues that affect amateur and professional
investors alike and explain different ways these issues manifest themselves
in everyday life. We also offer some advice on how to mitigate the negative
outcomes when the mind plays tricks on you. Being self-aware of these
factors is a critical first step.
Issue No. 1: How We Process Information
It is often said that we are living in the information age. With 24/7 news cycles
and handheld media devices, people have unparalleled access to information.
The human brain is amazingly capable of processing mass amounts of information
and experiences, but it too has limitations. Over time, individuals have
developed familiar heuristics or “rules of thumb” that aid in the processing
of complex or missing information. Of course, any time a shortcut is taken,
the margin of error increases. Even though we may believe that we approach
decision-making in an objective, rational manner, the lens in which we view
events is often tainted by heuristics.

2. Anchoring and Adjustment Confirmation Bias and
Cognitive Dissonance
A common strategy for estimating
unknown information is to start with Our innate desire to be right and
known information that serves as an avoid the embarrassment of being
anchor or reference point, and then wrong skews how we seek or process
make subsequent adjustments until information. This means seeking
a more accurate value is obtained. evidence that supports a viewpoint
Put simply, this is a crude system (confirmation bias) or rationalizing
of trial and error, often taking place evidence that disproves a viewpoint
subconsciously. The problem is that (cognitive dissonance).
we are predisposed to outweigh known Why do people with left-wing or
information (anchor) regardless of right-wing political views watch specific
its accuracy or relevance, and any programs or channels for their news?
“ et your facts first; then
G
adjustments are usually insufficient It is because they find it more pleasing
distort them as you please.”
in determining a precise result. to be exposed to information that
– Author Mark Twain
Think about whether you would they already believe. People may more
actually pay the full sticker price on commonly recognize this behavior
a car. Dealerships explicitly use that in the form of “selective hearing”
reference point to make a final sale when a spouse or child only hears
price more attractive. Just because what they want to hear – one form of
something is on sale doesn’t mean it confirmation bias. On the other hand,
is a good deal. Alternatively, wineries cognitive dissonance deals with denial,
use prices as a signal of quality and avoidance and rationalization.
sometimes list reserve wines at such a These biases can be harmful in investing
high price that all other bottles appear if people become emotionally attached
attractively priced. to an investment opportunity or lack
The process of anchoring and the objectivity to process information
adjustment is widespread in the rationally. There does appear to be less
investment business. Examples include dissonance when a recommendation
thinking that past performance has is made by another since there is now
predictive qualities or basing valuations someone to blame other than yourself.
on historical points such as 52-week The different responses to internally
high/low price. versus externally generated ideas are
something we see quite often.
Tips and Advice
Use various benchmarks or reference Tips and Advice
points to better triangulate. Past Employ objective screens when
performance should not set the selecting investments. For financial
precedent for future outcomes. Try to and non-financial decisions, play
understand why something is priced Devil’s Advocate with yourself, ask
the way that it is – there is usually a disconfirming questions, and use a
good reason. Realize that the margin trusted resource (including a Financial
of error in any decision is often larger Advisor) as a sounding board.
than you anticipate.
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3. Availability and Hindsight Bias Mental Accounting
When processing information, the Mental accounting is the tendency
mind tends to prioritize for ease of for people to separate their money
dissemination and recollection. Not into ‘accounts’ based on subjective
surprisingly, the newest information criteria, like source or intent, and act
and most vivid “stories” are given higher differently with the money based on
preference when it reconstructs memories. the account type.
This is called the availability bias. For example, found money (tax returns,
When purchasing a car are you more inheritance, bonuses, etc.) is often
apt to purchase based on 1,000 treated differently than earned income,
anonymous consumer reviews that with found money being spent more
rate it highly or your neighbor, who frivolously. Another common mistake
just purchased the car and it turned occurs when the financial transaction
out to be a lemon? Most people weigh takes place well before the consumption
the neighbor’s claims more heavily date. How many times have you
despite it being a sample size of only actually used a coupon book sold by a
one because it represents a more kid in the neighborhood raising money
salient example. for school? Surprisingly, sites such as
Groupon estimate that 20–30% of its
How could anyone have missed that
coupons go unused. This is because
there was a bubble in the housing
people tend to treat previous purchases
market? Wasn’t that obvious?
as a sunk cost and have already written
Hindsight is 20/20 and revisionist
it off in their mind.
history is rampant when money is on
the line, making people believe that Mental accounting impacts personal
an outcome is more obvious once it is finances because people segment their
“ he four most expensive words
T
already known. However, after-the-fact assets instead of taking a holistic view.
in the English language are
observations mask the uncertainty that Individuals must remember that a
‘This time it’s different’.”
occurs in real-time market analysis. dollar is worth a dollar no matter
– nvestor turned philanthropist
I
If someone would have acted on the where it came from.
Sir John Templeton
housing bubble, would they have
foreseen the liquidity crisis and ensuing Tips and Advice
recession? Perhaps not. Have your advisor create a financial
plan that includes all of your assets and
Tips and Advice make decisions based on the whole
Keep accurate records of why an puzzle, not individual pieces. View all
important financial decision was money the same and debt as negative
made and refer to it in order to help money (plus interest) – focus on both
prevent future mistakes. Don’t let sides of your personal balance sheet
abnormal, one-off events or wishful when making decisions.
thinking dictate your investment
strategy. Remain focused on the
Issue No. 2: The Role of Emotions
long-term and don’t let daily market
volatility or events drive emotions. Emotions are a powerful driver of
decision-making – particularly feelings
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4. of satisfaction and regret – and can Let us work through an example
quickly turn a rational thought to highlight this point. Suppose
process into an irrational one. you were presented with the two
Investing – or any financial investment opportunities. Option
transaction – has its highs and lows. A is a guaranteed payoff of $1,000
A useful way to begin to understand and Option B has a 50/50 chance of
how financial decisions are often earning $2,500 or $02. Numerous
made is to first recall what the studies have shown that the majority
process feels like. Buying a house select Option A, preferring the
is a great example. Initially, there certainty of earning $1,000 despite it
is great excitement when finding having inferior expected payoff relative
the perfect house for you and your to Option B ($1,250 or .5 × $2,500 +
family. Apprehension sets in when .5 × $0). This is a classic example of
signing reams of paper at the risk aversion.
mortgage closing. From there, you Now let us turn the situation on its
experience the joys and hardships head and talk about decisions that
of being a homeowner until it is time present losses. Now Option A is a
to sell, at which point emotional and guaranteed loss of $1,000 and Option
financial ties to the home cause you B has a 50/50 chance of losing $2,500
to value it very different from how or $0.2 In this situation Option A now
others value it. has the superior expected outcome
We dedicate this section to (i.e., losing less), yet studies have
exploring the psychological factors shown that individuals most likely
that cause investing to be a similar would choose Option B.
emotional rollercoaster. This is the fascinating revelation of
Prospect Theory Prospect Theory: when posed with
expected gains, individuals are risk-
At the core of behavioral finance is
averse, but when posed with expected
how investors feel about gains and
losses, individuals actually become
losses. The Prospect Theory purports
risk-seeking.
that people fear losing more than
they value winning. This concept was
Tips and Advice
first empirically tested in the 1970s
Try to spread out a gain as opposed
by Nobel laureate professors Daniel
to realizing the entire amount
Kahneman and Amos Tversky.1
immediately. When faced with
They quantified that the fear of losing
potential losses, sometimes
money is felt twice as much as the
it is easier to take one large loss and
joy of winning money, meaning that
move on than to prolong it into a
individuals are inherently loss-averse.
series of smaller losses. Don’t become
Before these findings, it was assumed
overly aggressive when trying to
that decisions were made rationally
make up for market losses.
based on the choice that presented
the highest expected gain or lowest
expected loss.
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5. Disposition Effect Issue No. 3: Misdiagnosing Skill
The Prospect Theory has clear and Luck
implications for many decisions The next set of common mistakes is
made in life because, at its core, it based on an investor’s perception of
is about how one weighs risks and how skillful he or she is at predicting
opportunities. It is therefore natural future outcomes. Egos are made and
for people to want to recognize good broken on a daily basis in investing,
feelings immediately and defer bad and these mistakes – namely
ones. The theory also goes a long overconfidence – can be among the
way in explaining the well-known most dangerous.
tendency for investors to hold on to Overconfidence
losing stocks too long and sell winning
How many times have you heard
stocks too quickly – known as the
someone tell you that they are 99%
disposition effect.
sure about something? How many
Investors often feel satisfaction when times were they incorrect? Probably
their investments show a profit and more than 1%. Overconfidence in
are quick to lock in those gains. behavioral finance doesn’t mean
Conversely, the pain of feeling regret that everyone is a narcissist. What it
will prompt many to hold on to a does state is that we tend to be too
losing position in the hopes that it will confident in the accuracy of our own
break even. The most comprehensive judgments, and believe we know the
study on this subject examined more solutions to complicated problems. This
than 10,000 brokerage accounts and inflated perception of skill can lead to
confirmed that losing stocks are held suboptimal investment decisions.
in a portfolio longer than winning
Underlying most financial transactions
stocks.3 Furthermore, over the
is the belief that the outcome will be
“
The most important thing to do subsequent 12 months after the sale,
a positive one. If that isn’t true, the
when you find yourself in a hole those sold for a gain had an average
transaction would likely not be made.
is to stop digging.” return that was twice as much as those
We purchase securities that we believe
– Investor Warren Buffett sold for a loss. Investors often cut
will increase in value, and sell ones we
short on great investments and hold
believe will decrease. Unfortunately,
hope for poor investments.
we are not as adept at fortune telling as
we think. Overconfidence can lead to
Tips and Advice
speculative investments. Studies have
Use set criteria for purchasing or
also shown that overconfident investors
selling securities. Incorporate new
trade more frequently and achieve
information as it comes available
below-market results.
and regularly evaluate your
decisions. Investment opportunities
Tips and Advice
rarely have infinite lives – there is
Allow third-party experts to
always a time to get in and get out.
invest on your behalf in areas where
Employ formal or informal stop loss
you don’t have expertise. Be honest
limits (when applicable).
when attributing success and failure
and set realistic expectations.
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6. Gambler’s Fallacy Herd Mentality
The role of fate or chance in financial As we’ve already discussed, people
situations is described as the Gambler’s respond most strongly to the newest
Fallacy. It is predicated on the belief information, so their reactionary style
that a streak will reverse or continue is not surprising. Add to that some
based on a series of past events. The overconfidence or the fear of not
most common example involves
keeping up with the Joneses and it
gambling. Think about a roulette
leads to herd mentality.
game that landed on red an amazing
11 consecutive times. The natural Groupthink – as it is alternatively
tendency is to bet on black since it’s called – stems from the fact that people
bound to land on it soon, yet in reality feel more comfortable making decisions
the chances are always 50/50, regardless that they see other people making.
of previous outcomes. Another casino This false sense of comfort can lead
example explains the peculiar behavior to suboptimal outcomes. In everyday
of someone rushing to a slot machine life, this is visible with fashion fads and
after watching someone else dump an TV programming. More dangerous
endless stream of coins thinking that
examples of herd mentality are asset
the machine is now “primed” for the
price bubbles and crashes, including the
next person. (Hint: slot machines are
most recent housing crisis.
programmed such that each pull is
given an equal probability of winning.) The pressure to conform to social
The concept seems easy enough to norms can be a strong influence on
avoid, yet everyone seems to fall prey to decisions. It is one thing to fall victim
“ skate to where the puck is going
I
it at one time or another. to a fashion faux pas, but quite another
to be, not where it has been.” –
In finance, the term Gambler’s Fallacy to put your wealth at risk because of the
Hockey player Wayne Gretzky
is most often replaced by reversion action of others.
to the mean. The same mistake
holds true with investments: people Tips and Advice
often assume that outperforming Make decisions based on what is most
or underperforming securities will
suitable for your investment style
somehow revert back to average (the
and financial situation. Think like a
mean) over time. While this does
contrarian by asking what everyone
happen, it is not guaranteed – some
is missing instead of fearing that you
investments are simply really good or
really bad. are missing out. Do your homework
before investing or use an advisor to
investigate ideas on your behalf.
Tips and Advice
Try to separate chance from skill.
In situations of chance, previous
outcomes should have little bearing
on your decisions. When viewing past
performance, try to understand the
drivers of those returns and whether
outperformance can continue or
underperformance will correct itself.
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7. Conclusions
Behavioral finance – once thought of as an unconventional theory – is now a
mainstream topic of academic exploration. It has broad relevance since it is not
only tied to investing but also explains why many common household decisions
are made. Some of the biases we have detailed have easy remedies. Others are
much more difficult, but simply having a constant awareness of the bias is a step
toward success. Financial Advisors can play a key role in this area. At Baird, we
take a holistic view when providing recommendations to our clients. Planning
for your future is as much about investment management as it is about risk
management – and we are prepared to address both.
“ rospect Theory: An Analysis of Decision under Risk.” Kahneman, Daniel and Tversky, Amos. March 1979.
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Investment options indicated are hypothetical and used for illustrative purposes only.
“ re Investors Reluctant to Realize Their Losses?” Odean, Terrance. December 1998. Journal of Finance.
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