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":

One of the Best Personal Finance Reads - "The Wealthy Barber"

One of the best personal finance books that I've ever read is the Wealthy Barber by David Chilton. The story starts with some friends looking for financial advice. They end up finding advice from a very unlikely source, their local barber. Their local barber is someone who is not expected to be wealthy but they soon find that he is very well off. The wealthy barber's finanacial status is not through an exceedingly high income but through extremely wise spending habits. I highly recommend spending the time to read this book. It covers a lot of personal finance topics such as life insurance, education funds and real estate.

One of the main messages of this book was to pay yourself first. This can be done by setting up a separate savings account that you will not access and putting aside a set amount of money every week or month into the account. It may be hard at first to stretch an already tight budget, but usually we spend what is within our grasp. Putting a set portion of funds aside on a systematic basis will divert funds that are available at your finger tips that you might spend impulsively and allows you to build wealth. It would be a good idea to start small i.e. $5 a week and slowly build it up as time goes by. When the money has accumulated into a significant amount it would be wise to invest it to accelerate its growth.