You may have heard the term "Behavioral Finance", but you may not know what it means. And you wonder... Is this something I should know about? Is this important to me? How does this impact my financial life? Well, here’s a primer.
- Behavioral Finance — a definition. Behavioral finance is the intersection of psychology and economic theory. It is the recognition that our thoughts and emotions impact the way we think, feel, and talk about money and other assets.
- Relying on your head. It’s all about the numbers, right? Classical economics believes that we are always rational and logical. Economic theory also assumes that we have a firm grasp on our self-control and that we will always behave in our own self-interest. As a result, our decision-making will always be reasonable and consistent. Of course, we all know that when it comes to money, sometimes we’re very good at making these balanced and common-sense decisions, and other times we’re a mess. That’s okay.
- Thinking with your heart. Part of understanding behavioral finance is acknowledging that there is an emotional component related to talking about and managing money. For many of us, money has a push/pull effect — a few steps forward, a few steps back. Money allows us to do some things that may or may not be in our best interests. Additionally, our feelings about money may prevent us from moving forward when we actually should. The point is, we make choices with our hearts. Own it.
- How to practice behavioral finance. A major component of practicing behavioral finance is understanding and appreciating our own behavior. Take a moment and think about your needs, your goals, and what’s important to you and your family. Sometimes, a choice we make about money is emotional. Other times, our logical self takes control of the decision-making process. We’re human; we’re inconsistent.
- Key components: Identify your goals — Understand your risk — Develop an investment strategy. Work with a financial advisor to make an assessment. How will you keep yourself accountable? How will you stay on track? You and your financial advisor can develop a plan that identifies your financial and personal goals. The result is that you will have a plan that accommodates both your head and your heart.
Interested in knowing more abut Behaviorlal Finance? Here are two excellent resources:
1) Emotional Currency by Kate Levinson, PhD. Athough primarily targeting women in this book, Dr Levinson discusses numerous issues that influence how we all-- men and women-- thnk about and therefore behave around money.
2) Personal Benchmark by Chuck Widger and Dr. Daniel Crosby. In this book, the authors discuss using a goals based investment strategy relative to your Personal Benchmark, vs. the S&P or any other market driven benchmark. The authors talk about the need to "frame" our goals based on what is important to us rather than to others.