INTRO TO BEHAVIORAL
FINANCE
THE LEADING EDGE
OF INVESTMENT MANAGEMENT WISDOM
As investors, we all have goals, a desired lifestyle and we
must evaluate our capacity and tolerance for risk (investment management). We
develop plans, strategies, and then we go about living. On a daily basis, we
operate and make decisions and modify our plans and alter strategies, then we simply
act in accord, OR we act contrary to all that great planning. Those daily
decisions are greatly influenced by our emotions, thoughts and behaviors around
money. We want these decisions to be the best decisions possible.
Behavior Finance is the study of how humans, with all the
tendencies of our human-ness, make money decisions. Some wise, some not so
wise. We can learn much as investors through some basic understanding of this
exciting new academic field.
The expert, Daniel Kahneman, Ph.D. (BA psychology/minor mathematics)
(Ph.D. psychology), in 2002, was the first in the field of social scientists to
win the Nobel Prize in Economic Sciences. His work in Prospect Theory included
the psychology of judgment and decision-making, behavioral economics and
hedonic psychology. He teaches psychology at Princeton. So what does this all
mean?
“Hedonic psychology
(closely related to the positive psychology movement in the 1990’s) …is the
study of what makes experiences and life pleasant or unpleasant. It is
concerned with feelings of pleasure and pain, of interest and boredom, of joy
and sorrow, and of satisfaction and dissatisfaction.” (Kahneman, Diener &
Schwarz, 1999, p. ix)
Basically what Kahneman has concluded in his research is
that the more confident you are in your judgments, then the happier and more
satisfied you will be with your money decisions.
How is this relevant to you or to Button Financial? The
leading edge in investment management is based on the “efficient market
hypothesis and modern portfolio theory.”
These principles are used by institutional investors (endowments and pensions)
and the majority of investment advisors (including Button Financial). They are
the most widely acceptable, proven investment principals today. HOWEVER, these
principals are based on the assumption that markets and investors are RATIONAL.
Financial Services Professionals are now beginning to apply
Kahneman’s theory to investing. Humans too often react UNRATIONALLY as
investors which results in decisions that end up with undesirable results.
Knowing that investors are UNRATIONAL, the thinking and emotions that result in
faulty decisions and harmful behaviors are being identified. These been
labeled “biases.”