What is Behavioral Finance?
According to a study by DALBAR, Inc., the S&P 500 had a return of 7.20 percent over the past 20 years, while the average stock investor had a return of 5.29 percent over the same period. The Barclays Bond Index had a return of 4.60 percent, while the average bond investor had a return of 0.44 percent1.
Why do Investors Perform so Poorly Compared to Unmanaged Indexes?
For some time, we have known about the disconnect between traditional finance thinking and the reality of investing. Traditional finance states that investors will make unbiased, rational choices based on risk tolerance (risk versus return trade-off). Reality, however, has shown that people are often biased and irrational in their decision-making.
In addition, humans are more loss-averse than they are risk-averse. The human brain is hardwired to avoid danger, real or perceived, and that process can override our rational thinking, causing us to make emotionally-driven decisions.
As a result, we often let emotions (e.g., greed or fear), or biases (e.g., loss aversion, recency bias or fear of missing out) influence us, causing us to make bad investment decisions. The average person underperforms the S&P 500 or Barclays Bond Index over any given timeframe not because of poor investment selections, but because of poor investment decisions.
Behavioral finance blends the studies of traditional finance, psychology and neuroscience. Its aim is to help us better understand how emotions and biases can negatively influence investment decisions and then help us learn how to avoid those negative effects.
Per Vanguard’s Alpha Study2– Good advice from a Financial Advisor is worth around 3% in net returns over time. 150bps (1.5%) comes from Behavioral Coaching(so half the value a good advisor brings to the table is helping clients manage their behavior and make better decisions), 70bps (.70%) comes from spending strategy and 75bps (.75%) comes from asset location (not allocation).
Hunt Country Wealth Management’s Chris Merchant is a trained Behavioral Financial Advisor™. He integrates concepts of Behavioral Finance into our financial planning and advice to help our clients increase their self-awareness, expand their choices, and ultimately make better values-based decisions.
Behavior Economics has been awarded the Nobel Prize six times since its inception in 1968.
1Dalbar, Inc. Research & Communications Division, “2016 QAIB Quantitative Analysis of Investor Behavior.” Advisor Edition, April 2016.
2*Source: Bennyhoff CFA, Donald G., & Kinniry Jr. CFA, Francis M. (2016, June). Vanguard Advisors Alpha: Vanguard Research. https://www.vanguard.com/pdf/ISGAA.pdf
Chris Merchant is available for commentary and speaking engagements related to retirement income planning. He is a CERTIFIED FINANCIAL PLANNER™, Behavioral Financial Advisor™ and author of: