Behavioral finance is a field that sits at the intersection of psychology and economics. It shines a light on how investor psychology affects real-world decision making. It challenges the long-held notion that investors will always act rationally and in their best interests.

Behavioral finance is a field of study, but it can also serve as a guidepost for financial advisors and investors alike. Understanding the principles of behavioral finance can help you identify your cognitive biases and follow a financial plan that fits your goals without letting emotions throw you off course.

From Tulips to Tech: A Brief History of Asset Bubbles

Asset price bubbles are not a recent phenomenon. The Dutch Tulip Mania in the 1600s happened when the rich chose to drive up the price of tulips to astronomical levels. They collected tulip bulbs and hoped to sell to the next greatest fool. It eventually popped.

In the 1700s, the South Sea Bubble in Britain created massive wealth for shareholders when the prices of the South China Sea Company went up eightfold.  Those same shares collapsed and created an economic crisis.

In modern times, the Japanese stock market bubble peaked in 1989 and fell 80% over the next 20 years. In the United States, the late 1990s technology bubble witnessed the Nasdaq fall by 80%.

In hindsight, it is safe to say that these financial manias weren’t driven by deep research and analysis. Instead, they were driven by investors making emotional decisions due to their inherent biases.

The Rise of Behavioral Finance

To economists prior to the 20th century, the mind, emotions, and human behavior had no place in economics. The core assumption of economics at the time was that human beings always act rationally. The basis of all decision making assumed we did not have a flawed, emotional, 250,000-year-old operating system in our heads. To old-school economists, our brains were rational actors.

In the real world, we now know that this is not the case.

Today, behavioral economics focuses on flawed human behavior. It understands that humans aren’t rational actors. We’re more prone to act out of emotion and our own biases rather than based on pure economic rationality.

The good news is that this research into investor psychology has allowed financial advisors and other professionals to understand their clients better. By understanding why people make certain investing decisions, we can better help them overcome these biases and guide them in the right direction.

Daniel Kahneman: The Psychologist Who Transformed Investing

Daniel Kahneman, who passed away in 2024 at the age of 90, was the “grandfather of behavioral finance” and a Nobel Prize winner. His research from the 1970s and 1980s formed the basis for bringing psychology to the field of economics.

This was revolutionary compared to prior standards.

As Jason Zweig summarized Daniel Kahneman’s work in his column, “The Psychologist Who Turned the Investing World on Its Head:”

“Danny answered questions about ‘Why do we sell our winners too soon and hang onto our losers too long? Why don’t we realize that most hot streaks are just luck? Why do we say we have a high tolerance for risk and then suffer the torments of the damned when the market falls? Why do we ignore the odds when we know they’re stacked against us?’”

Kahneman was the first to bring up many of the financial theories that exist today about why humans make the decisions they do, especially as it relates to their personal finances. 

Common Cognitive Biases That Derail Investors

Kahneman brought attention to the investor biases that people often run into when it comes to money. These behavioral traps can cause us to make irrational - and often less than ideal - decisions with our personal finances.

Loss Aversion

Generally speaking, losses feel more painful than gains feel good. As a result, we may avoid risk in the interest of avoiding loss, even if it means we’re missing out on larger gains.

Overconfidence Bias

People generally overestimate their own abilities. Overconfidence leads people to believe they’re better at something than they actually are (like day trading, for example). This could lead to some investors taking on an unnecessary amount of risk.

Anchoring Bias

Anchoring bias states that people tend to attach themselves to the first piece of information they learn - this is the anchor - which then affects their decision making moving forward. This makes it difficult for people to learn new financial habits or take advice from advisors. They may question this new information if it contradicts their initial reference point.

Herd Mentality

You probably already know that most people like to follow the crowd, and that’s just as evident in personal finance as it is anywhere else. Today, we might refer to herd mentality as FOMO - fear of missing out. 

It’s what leads to market manias and trends, from the tulip mania in the 1600s in the Netherlands, to the GameStop rally in 2021. It often causes investors to make decisions that aren’t in their best interests simply because other people are making them.

Disposition Effect

Disposition effect is a cognitive bias where investors sell their winners too soon and hold onto losers too long to avoid taking a loss. It’s the result of emotional decision making, where people want to lock in their gains but not their losses.

Putting Psychology Into Action: 5 Practical Strategies

Knowing about financial psychology isn’t enough - it’s important to have strategies to put into action to protect your investment portfolio and reach your goals. Here’s how to put a system in place to apply these psychology theories to your own finances.

1. Recognize and Mitigate Biases

First, being aware of our biases can help us avoid mistakes when the stakes are high. An example of this is herding. We want to belong and go with the group, and recognizing this bias can make us aware of a mania that is pulling all kinds of people into it. If it’s driven by a narrative rather than fundamentals, caution would be warranted.

Not all investors will be most prone to the same investing biases. Instead, it’s important to take a hard look at your own so you can best address them.

2. Diversify Across and Within Asset Classes

A second important strategy is diversification. We use diversification in two different ways. First, we diversify across asset classes - equities, bonds, alternatives, and cash. Each provides key sources of returns and risks for an overall portfolio. Stocks are generally believed to provide growth, bonds are thought to provide income, alternatives are thought to provide differing risk exposure, and cash may allow for the optionality of future opportunities.

In addition, we are diversifying inside each asset class. For example, while passive index exposure can make sense in certain asset classes, for bonds, it may not be the best way. The most widely followed bond index is the Bloomberg Aggregate Bond Index. Yet it covers only half of the U.S. bond market. It excludes areas like municipals, securitized bonds, and many corporate credits. Sizing each holding at the right percentage weight is key. That way, when one fund or manager’s style is out of phase, you can rebalance back into these strategies.

Diversifying within asset classes happens for every type of asset, not just bonds. It’s important that your portfolio includes plenty of market depth, even if it requires both active and passive strategies to achieve it.

3. Systematically Rebalance to Reduce Emotional Triggers

Rebalancing is one of the most effective ways you can reduce emotional triggers. Having a systematic process for both buying and selling helps alleviate the herd mentality. We use strict and data-driven guidelines for when those rebalances will occur. Whether it is price levels of the market or a percentage from the allocation, rebalancing guidelines can help lower the timing luck and avoid getting too concentrated or too underweight to strategic targets.

4. Avoid the Endowment Effect Through Planning

A fourth strategy is overcoming the endowment effect. When doing a financial plan, we often find investors are not positioned to achieve their long-term goals. But change is difficult! The endowment effect is what we want to avoid. 

This is when investors tend to be overly enamored with what we already own, even when evidence is shown that we should change. By providing the catalyst for changing a portfolio, we can help get into the proper asset allocation based on the financial plan.

A financial planner can take an unbiased look at your current investment allocation and advise you on any changes you should consider. Having a specific and tailored plan in place can help counter your resistance to change.

5. Become a Smarter Information Consumer

A final strategy to help you put financial psychology into action is to be an information filter. We understand there are a lot of opinions and loud voices on CNBC, Bloomberg, and the Wall Street Journal. Fortunately, we don’t have to act on them. Even better, it helps not to listen to most of them at all. They don’t know your personal situation and may have their own agendas to push.

Instead of taking every piece of financial advice or information you hear to heart, filter those inputs and focus on your own long-term investment strategy, prioritizing diversification and rebalancing, along with an investment plan that’s designed with your goals in mind.

The Role of a Financial Plan in Behavioral Discipline

In the end, our own psychology often works against us, but it doesn’t have to. Success comes down to having a well-established financial plan that outlines financial goals, risk tolerance, and the investment strategy to achieve this. Having a clear plan in place can help you stay focused and avoid making emotional decisions that do not align with the long-term strategy.

A financial advisor can often act as a behavioral coach. A good advisor can help you see and question your own biases to change your investing behavior. While your instinct might tell you to make a rash decision, your advisor can ease your fears and help you stay the course of your financial plan.

Turning Behavioral Insights into Long-Term Investment Success

You’ve learned that your success with money likely has just as much to do with your cognitive biases and emotions as it does with your financial acumen. The good news is that while behavioral biases exist, they can be managed. By having a solid financial plan in place, along with an awareness of your own biases, you can build a portfolio that fits your financial goals and isn’t vulnerable to emotional decisions.

Working with a financial professional who understands not just markets but also minds can help you notice your own biases and acknowledge them without allowing them to derail your financial plan.

Frequently Asked Questions

Q: What is behavioral finance?

A: Behavioral finance is the study of how human emotions and biases influence investment decisions, often leading to irrational outcomes.

Q: What are the most common investing biases?

A: Loss aversion, overconfidence, anchoring, herd behavior, and the disposition effect are among the most well-known investing biases.

Q: How can I avoid emotional investing?

A: You can avoid emotional investing by creating a long-term plan, using diversification, automating rebalancing, and understanding your own biases.

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