Benefit From Behavioral Finance - Forbes.com
Intelligent Investing
Benefit From Behavioral Finance Michael Ervolini, 07.07.09, 02:30 PM EDT
There is more going into your investment decisions than you think. Behavioral finance can help you know your unconscious brain.
Excerpts:
Investment decisions aren't really about deliberating risk and return. Surprisingly often, they are swayed by subconscious decisions that produce knee-jerk reactions. Research suggests that emotions are essential to decision making, however, not just a weakness that needs to be overcome. Emotions are, it turns out, especially useful in helping us make decisions when we face lots of choices. Yet unguided emotions can overwhelm investment thinking and push us to financial mistakes. Professional investors increasingly are investing in their own self-awareness to contain emotional missteps. At their own level, so can individual investors. And that brings us to three basic building blocks for self-aware investing: the role of the unconscious, emotional thinking and the value of a plan.
As much as 95% of all thinking occurs in the unconscious brain where we store beliefs, rules-of-thumb, biases and emotions. Unlike the ploddingly sequential processing that happens in the conscious brain, the unconscious is lightening fast and can work on multiple elements of a problem at once. If the conscious brain is an abacus, the unconscious brain as a super computer. The abacus does as you instruct it within its limitations. The computer offers much more potential, but will only do exactly what is commanded, which can be very different from what you want. That's how we get in trouble. Since we can't probe and review the beliefs, fears, heuristics and other instructions within the unconscious, it often makes decisions that are not in line with our purpose. Bad habits affect investing the same way they cause trouble in sports.
Two forces within the unconscious battle for supremacy--logic and emotion. Logical thinking involves making the most reasonable use of, or explanation for, the information available. What scientists call achieving the best fit for the data or what you and I might term "connecting the dots to draw the clearest picture." In contrast, emotional thinking is about making us feel good and avoiding discomfort. The unconscious does this by interpreting information to support existing beliefs and to stay clear of fears or conclusions that might challenge our beliefs. This interplay between logical and emotional thinking is called Motivated Reasoning. Remember the image from the freshman psychology book that can be interpreted as a vase or an old woman. The data or image never changes, but different people are motivated to see one resolution or the other. This dual interpretation of facts helps explain why the same drop in the Dow is, for some, a buy signal, and for others it triggers a sell.
Experience alone will not guarantee that you make effective financial decisions. To the contrary, experience is often how we learn to make poor judgments. It turns out that we learn much of what we know unintentionally or unconsciously. That makes it all too easy to make wrong associations and learn that A, B, C are usually followed by K. A common form of such faulty learning is termed Self Attribution. We ascribe the positive outcomes in our past to our good choices, while dismissing poor outcomes as the fault of others--a fickle market perhaps or decisions we really did not want to make anyhow. Such skewed thinking generally results in over-confidence in our abilities and under appreciation of risk. This kind of thinking can reek havoc on your portfolio.
Read full article: http://www.forbes.com/2009/07/07/ervolini-behavioral-finance-intelligent-investing-commentary.html
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This posting was made my Jim Jacobs, President & CEO of Jacobs Executive Advisors. Jim also serves as Leader of Jacobs Advisors' Insurance Practice.
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