I’ve always been a little confused about the term behavioral economics. I think the term really should be behavioral psychology. After all, it’s really about how you behave around money issues not what you do with your money.
You may have read the statistics that say the average investor gets returns that are much lower than the market. If you spend any time reading about behavioral economics you’ll understand why.
Here are some things you might want to think about:
You don’t act rationally about your money.
Economists seem to spend an awful lot of time scratching their head about why you don’t act in a rational manner. After all, you have all the information you need. You might even read the Wall Street Journal, The Financial Times and The Economist religiously. Yet still you jump in and out of the market at the wrong time.
That’s OK, you’re human. It’s also the best reason to have a good advisor working with you. Your advisor can help you understand what you’re going through is normal and guide you with wise decisions. That is of course if your advisor understands what wise advice is.
You might want to jump in or out of the market at the wrong time.
Research by Dalbar has shown that the average investor gets returns that are much lower than the market. Economists seem to miss the point why. Behavioral economists don’t have any questions why.
The Behavioral economist knows that your tolerance for loss is very low. You’re often going to jump out of the market right when you should be buying. It takes a lot of discipline to stay with a strategy during down cycles. Knowing what you’re going to do before the inevitable downturn is always a good idea.
You think you make more and spend less than you do.
I find this is almost always true in the financial planning process. When I ask clients how much money they make the answer I get is 20 to 50% more than they really do. The same is true for expenses. Clients tell me their expenses are often as much as 50% less than what their expenses really are.
This is a natural thing. Human’s are optimistic and sometimes to a fault. When planning you don’t want to think less than you need. Look at your tax returns for income and add up your checkbook for expenses. If you own a business, don’t forget to include personal expenses your business pays. Now you’re ready to do some real planning.
Sunk costs is a morass you want to skip.
Have you ever talked with someone whom you know have lost a lot of money but they can’t bring themselves to give up on the investment. Good investors know that there is a time when you have to cut your losses.
It’s not only money that will get you on sunk costs, it’s also effort. If you spend a year getting ready to do something you’re less likely to accept evidence your idea is a bad one. On the other hand, if you spend three months, with the same evidence it’s pretty easy to give up on your idea.
Plan thoroughly but not too thoroughly. Make sure you put major effort into major changes and minor effort into minor changes. Too often you spend time on trivia when you should spend time on ideas that will make a big difference in your life.
You might have what’s called a recency bias.
This is a big problem, especially in the investment world. If you believe that what happened yesterday will happen tomorrow you’re going to have a problem with your investments.
There’s a reason we suggest a diversified portfolio. We have no idea what’s going to happen tomorrow and we know that the past is a lousy indicator of the future. I hope you do also.
Learn a little about behavioral economics. It’ll help you understand why you make the same investing mistakes over and over. I know it helped me in the advice I give and I hope it’ll help you in decisions you make.