This past week I had the opportunity to visit Salt Lake City for the Spring Conference of the National Association of Personal Financial Advisors (NAPFA). The theme of this year’s conference was Behavioral Finance. A hybrid of psychology and economics, this exciting field aims to explain our behavior and decision making in our personal finances. Some examples of application to our behaviors around money include:
- Tendency of individuals to overestimate their own abilities and believe they are above average. This explains why so many fall for the fallacy of active investment management. They try to beat the market by selecting investment securities based on prior performance or time their purchase of securities to beat the market.
- Focusing too narrowly on frames of references or over-weighting recent events. For instance, a short term fluctuation in the market might cause an individual to perceive higher risk than actual longer-term risk and sell stocks at exactly the wrong time.
- The power of momentum, when we fail to take action that is in our best interest. In other words, procrastinating on actions we know we need to make but simply put off. This may affect getting that life insurance policy, signing our estate documents or rebalancing our portfolio.
The point of Behavioral Finance research is to explain how our past experience and mental processes can get in the way of day to day decisions. Even more importantly, it seeks to understand how to overcome these mental biases. Dr. Meir Statman, Professor and Author of What Investors Really Want, describes these biases as similar to having less than perfect vision. By understanding where our behavior and economics intersect, we can correct that vision and make better decisions.
Understanding behavior and how it can affect reaching financial goals is a top value of hiring a Financial Planner. Value does not come from number crunching, projections, or investment management alone. Value received is your advisor seeing the whole picture of your life, and tempering emotions with appropriate decision making. A trusted advisor encourages you to reach your goals by keeping you accountable and on track through a series of small, incremental decisions.