3 Things You Need to Know About Behavioral Finance

Everyone knows that the secret to successful investing is based on one basic idea—buy low and sell high. But if it was really that easy, we’d all be as rich as Warren Buffet. So why is it so hard to put that simple principle into action?The answer it turns out is all in your mind. According to academics who study behavioral finance, the way our brains are wired can interfere with making the best financial decisions. Researchers such as Daniel Kahneman, who won the 2002 Nobel Prize in Economics for his work in this area, have discovered that, because of fears and biases, otherwise rational individuals often make irrational decisions when it comes to money and investing. These behaviors are apparent in all aspects of our lives, but can be especially damaging when it comes to money.

You Need to Have an Open Mind

Confirmation bias is one of the most common irrational financial behaviors. This is when we look for opinions that reinforce what we already believe. To see this bias in action just look at the political landscape. People tend to gravitate toward news outlets that reflect their political orientation—Fox News on the right and MSNBC on the left—and write off contrary viewpoints as “fake news” or distortions of the facts. Living in such an echo chamber causes us to filter out potentially valuable information and, as a result, make a less than optimal decisions.When it comes to investing, confirmation bias can be especially costly. Failure to research investments thoroughly and to consider multiple perspectives can lead to buying or selling at the wrong time or making a bad investment choice in the first place.Related: Financial Literacy: What You Don’t Know Could Hurt You

It Hurts Too Much to Lose

Another irrational behavior that can harm investors is the fear of losing money. Obviously, the goal of investing is to make a profit, yet behavioral finance researchers have found that investors react much more strongly to loss than they do to a gain of an equal amount. One of the experiments conducted by Daniel Kahneman and his research partner Amos Tversky asked participants to bet on a coin flip. If the coin came up heads, they’d win $20, but if it was tails they would lose $20. They got few takers. Most people wanted a much higher payout—as much as double—before they were willing to take a chance on losing.This fear of loss leads many investors to adopt a “wait until I break even mentality.” When faced with a losing investment, they refuse to sell until the price comes back to where they bought in. A much more rational behavior is to look at the facts dispassionately, admit when you’ve backed a loser and get out while the getting’s good.

You’re Not as Smart as You Think

A third irrational behavior that investors should be wary of is overconfidence. We all like to think we’re like the kids in Lake Woebegone, where everyone’s above average, and tend to overestimate our own decision-making abilities. But in reality not everyone’s looks are a 10, or even a 7; and however you measure it on any scale, about half the people are going to be below average. To have the best chance of achieving success, investors need to understand the difference between confidence and overconfidence. Confidence, when it’s based on a realistic assessment of one’s abilities, is a valuable personality trait. Overconfidence on the other hand, can lead to making investment decisions based on ones’ gut feelings rather than objective, reliable research, often with disastrous consequences.Overconfidence often fools investors into thinking they can time their buying and selling of securities in order to beat the market. In reality, research has found that overconfidence can lead investors to under-diversified portfolios, gains eaten up by trading costs and overall subpar performance.It’s probably no surprise that men tend to be more overconfident when it comes to investing (and other things as well). Only nine percent of women in a Fidelity Investments survey believed that they could get better investment returns than men. In reality, an analysis of more than eight million Fidelity clients found that a majority of women achieved higher returns than men.The innate biases that behavioral finance researchers have identified give the lie to the old adage that what you don’t know can’t hurt you. When it comes to financial matters, knowledge is power. The more you know, both about the financial markets and why you do the things you do, the more likely you’ll be able to meet your investment goals.