Sunday, October 28, 2012

What is behavioural finance?


What is behavioural finance anyways? Sounds like overly complicated jargon, but it's actually an interesting subject of study that has come about over the last decade or so. Behavioural finance is the study of how people react to market conditions as a whole and how this reaction in turn effects the markets. It's the study of economic mob mentality and when it comes to your investment portfolio it can be an important factor.

Understanding the psychology of how we make financial decisions is critical for our long term financial health. We would like to believe that all our financial decisions are well thought out and calculated, adjusting for risk and maximizing the returns. In reality a lot of our decision making is irrational, driven by two main emotions. Fear and greed. Like a recovering alcoholic, the path to recovery is to acknowledge that you have a problem and take steps to mitigate the problem.

In Carl Richards' "The Behavior Gap", the topic of behavioural finance is discussed with emphasis on how understanding the role of money in one's life can lead to a healthier wealthier one. Here are three important lessons from this book:

1) There's a difference between investment return and investor return. Investment return is the amount your investments will earn over the lifetime of the investment, given that you do not make any adjustments to the investment. Investor return is the actual return you receive, which in most cases is lower. This is caused by jumping in and out of the investment as a result of the fear (when the markets perform poorly) and greed (vice versa). The difference is what Carl calls the behavior gap.

2) The more you make, the happier you'll be (only to a certain point). There is a point when extra income won't make you any happier. There was a recent study by Noble Prize winning economist Daniel Kahneman that showed there is little increase in happiness after earning more than about $75,000 a year. It's hard to quantitatively measure happiness, but the idea is that once your basic needs are met and you have some extra to travel and have a few perks, you may meet a plateau of happiness with earnings. Also, the extra earnings may not be worth the extra stress it comes with.

3) Financial plans are worthless. Since most are based on assumptions and try to extrapolate out to decades into the future, financial plans need to be flexible. Having an idea of where you want to be financial is good, however the idea of having a rigid financial plan is useless. Life has many unexpected bumps that can lead you way off course from your financial plan. Instead its best to have guiding principles that help you make financial decisions that are in line with your long term goals.

Here's a video where Carl explains the "Behavior Gap":


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