The Psychology of Profit: Behavioral Finance & Your Investment Strategy
In this episode, Elliot Kallen and Jenifer Bloodsworth explore the fascinating intersection of psychology and Finance. Understanding the two thinking systems in our brains can shed light on why we sometimes make irrational investment decisions. They also cover how to combat common biases and build a resilient portfolio that can withstand market volatility and global risks. The insights gained could be a game-changer for your long-term financial success.
Meet Our Guest
Jenifer Bloodsworth
National Account Manager | First Eagle Investments
Jenifer Bloodsworth is a 2022 graduate of Columbia University’s M.P.S. in Wealth Management program and a founding donor of the Wealth Management Advancing Diversity Fellowship Program. Bloodsworth is now a National Account Manager at First Eagle Investments. She frequently is one of a select few seminar presenters on behavioral finance.
Understanding the Impact of Financial Psychology on Wealth Management
Financial psychology involves the study of how our thoughts, emotions, and behaviors shape our financial decisions and outcomes. It includes aspects such as goal setting, attitudes toward Money, and investors’ financial well-being.
This discipline is related to behavioral finance, a field that examines how biases and irrational behaviors can impact financial markets. Concepts such as investor sentiment and herding behavior fall under this purview. Essentially, the way we perceive and manage money influences our finances and, on a larger scale, affects the dynamics of financial markets.
Harnessing Market Volatility: A Key Aspect of Investment Strategy
Volatility is a fundamental part of an investor’s journey. Throughout an investment lifetime, one encounters various highs and lows, booms and busts. This is an unavoidable reality for all investors.
Volatility swings both ways—it can be beneficial as well as detrimental. However, investors tend to feel the sting of losses more intensely than the exhilaration of gains, as numerous studies have revealed. Despite this, one can turn volatility into an ally by viewing it as a creator of buying opportunities.
When the market retracts, it pulls back everything, sometimes causing even high-quality stocks to depreciate temporarily. It’s comparable to spotting an expensive olive oil brand on sale at the grocery store—you might seize the opportunity to buy a couple of extra bottles.
Investment Wisdom dictates that we should buy low and sell high. However, executing this strategy can be challenging. This is where financial psychology and behavioral finance come into play. They don’t just affect us as individuals, but can also have collective impacts on markets.
Decoding Money Scripts: The Key to Better Financial Communication and Empathy
One commonly held assumption is that individuals think their personal attitudes toward money are universally shared. However, this is not the case, and such misconceptions, especially within Relationships, can lead to confusion and friction.
A component of behavioral finance or financial psychology that I find particularly fascinating is the concept of ‘money scripts.’ These are essentially our ingrained beliefs about money that we carry through life. Understanding someone’s money script can help facilitate more productive financial conversations and build empathy.
Over time, our approach to financial risk and our investment aggressiveness can evolve. For instance, someone in their 20s may be more inclined to invest aggressively compared to their older selves, who may be more conservative due to shorter time horizons and increased responsibilities. It’s crucial to maintain open discussions about financial needs and comfort levels with those who are financially connected to you—be it parents, spouses, children, or dependents.
Consider Market and Longevity Risk
Moreover, it’s important to consider not just market risk, but also longevity risk. Are you Investing aggressively enough to meet your goals?
While considering these risks, it’s essential to remember demographic nuances. For example, women tend to live longer than men and often face different career trajectories. As such, their investment needs might differ significantly. There’s a common assumption that women are more risk-averse, which is partly supported by data. However, when women are as financially educated as men, they show similar risk tolerance. Therefore, financial Education can help women understand and effectively manage their investment risks and goals.
Risk is a nuanced concept that’s often misunderstood. Like the saying, “Everyone has a plan until they get punched in the face,” many people consider themselves aggressive investors until the market becomes volatile. This is where understanding risk and financial education become crucial for sound investment decisions.
Empowering Women in Financial Decision-Making: The Importance of Involvement and Understanding
Well, from my perspective, the assertion that women generally want more information and seek an attentive listener rather than someone talking at them is not just academic conjecture—it holds in financial psychology as well.
Women must be involved in financial decisions. While I work in finance and actively participate in my household’s financial planning, I’ve noticed that many people choose to delegate these responsibilities. Sometimes, in an attempt to divide and conquer, women may feel comfortable letting their partners take charge of financial matters.
However, I strongly urge women to be part of this process. Even if the world of finance seems intimidating or perhaps less interesting, it’s important to remember that these decisions will affect you directly. Your opinions, feelings, level of comfort, and the Security you seek matter and should be represented in these decisions.
Women may indeed ask more questions and require more information to reach a comfort level with their finances. It’s essential to collaborate with a financial advisor who listens, takes the time to answer your questions, and ensures you understand the details. After all, it’s your money—it’s your life. This is the funding that will help you realize your dreams and aspirations, whether it’s for you or your children.
Money isn’t just about accumulating wealth; it’s about what you can achieve with it. Encouraging more women to engage in financial planning not only fosters better understanding but also empowers them to take control of their financial futures.
The Dual Systems of the Human Brain and How They Impact Investing
Allow me to delve a little bit into how our brain works and how this impacts our financial decisions.
The renowned book, “Thinking, Fast and Slow” by Daniel Kahneman, proposes the idea of two distinct systems operating within our brains. Financial psychologists subscribe to this theory as well.
System One: Fast Thinking
The first one, System One, is the ‘fast’ part of our thinking, characterized by automatic, knee-jerk responses. This system governs our immediate reactions, emotions, and memories. An example of System One thinking would be the automated solution of simple arithmetic like ‘2+2,’ which our mind answers without any conscious effort. System One, like a marathon runner, is always active, making subconscious decisions for us, which are necessary for our daily lives.
System 2: Slow Thinking
System Two, on the other hand, represents our ‘slow’ thinking. It’s responsible for the logical and analytical part of our cognition, akin to a strength athlete capable of heavy lifting. This system comes into play when we’re faced with complex problems like the multiplication of large numbers.
While you might think it’s beneficial to always engage System Two due to its logic-based reasoning, both systems have their limitations and are vital in their unique ways. System Two can tire; it has limited endurance. Ever experienced a day when you strictly followed your Diet plan for breakfast and lunch, only to end up with ice cream for dinner? That’s because, after a day of decision-making, System Two is exhausted, and System One steps in to comfort you with a sweet treat.
The Limitations of Both Systems
The limitation of System One is its reliance on shortcuts and heuristics, leading to potential biases and incomplete thinking. This becomes evident when investing.
The principle of ‘buy low, sell high’ is a logical strategy endorsed by System Two. However, due to System One, we might fall prey to ‘recency bias’ – the tendency to give more weight to recent events when predicting future outcomes.
During a bull market, investors may keep investing more, expecting the uptrend to continue due to recent positive performance. Conversely, in a bear market, investors might panic and withdraw their investments, fearing the downtrend will persist.
In both scenarios, System One overrides System Two, leading us to collectively act contrary to logical investment strategy – investing more at market peaks (high prices) and pulling out at market lows (low prices). Understanding the dynamics of these two systems can help us navigate the pitfalls of behavioral finance and make wiser investment decisions.
Navigating Behavioral Finance Pitfalls: Practical Tactics for Different Scenarios
Let’s discuss three common scenarios where behavioral finance plays a significant role and outline tactics to navigate them effectively.
Scenario 1: Knowing what you should do but finding it difficult to follow through. In a volatile market, it can be challenging to maintain a consistent investment strategy such as dollar-cost averaging. A way to tackle this is through automation. Work with your financial advisor to set up automatic contributions from your bank account to your investment account. This ‘set it and forget it’ approach alleviates the mental load of having to decide every time you need to invest, making the process more efficient and less stressful.
Scenario 2: Feeling anxious during market volatility and unsure of what to do. This scenario might often include getting influenced by friends’ advice or financial pundits on TV. This suggests an information gap, and it’s where your financial advisor can step in with education. They can provide historical market context, explain the factors driving the current volatility, and discuss what actions might be appropriate in the given circumstances. Filling this information gap empowers you to make more informed decisions.
Scenario 3: Experiencing a strong urge to make an illogical decision. In times of extreme market volatility, some investors might feel compelled to pull all their investments out and convert them into cash, fearing a market crash. But such panic-driven actions often lead to poor outcomes. Instead, consider your financial advisor as a coach to help confront these fears. They can simulate the impact of severe market downturns on your portfolio and discuss various alternatives.
For example, if you’re retired, they can show you how a 30% market downturn might affect your income stream and what adjustments might be necessary. The options can range from tweaking your investments, adjusting your Lifestyle, selling an asset, or even considering part-time work. The idea is to understand that there are multiple ways to mitigate risks beyond just liquidating your investments, which could expose you to other potential risks.
Implementing these tactics can help mitigate the impact of behavioral finance issues on your long-term financial health.
Building Long-term Financial Resilience Amid Market Volatility and Global Risks
Market volatility periods can serve as a unique opportunity to reassess your investment strategy. This could involve reviewing the risk levels in your portfolio, rebalancing your investments, and questioning if your portfolio is correctly aligned with your long-term goals.
One of the common biases to check for is over-concentration in one region, such as the US. Although the US has been in favor for quite some time, it’s essential to remember that there are quality companies worldwide. Therefore, periods of market volatility can be an excellent time to engage your financial advisor in discussions about diversifying into international stocks.
In addition to diversification, navigating possible global risks necessitates building a portfolio with a resilient nature. Although the future is unknowable and macroeconomic issues can present challenges, the goal should be to invest in high-quality, stable companies that offer some level of defensive capacity against disruption. Finding these companies and investing at an attractive price is a sound approach.
Building in defensive measures into your portfolio, like cash and gold, can also be advantageous, providing a buffer during volatile times. The key is to build resilience proactively, as unforeseen events often offer little time for effective reactive measures.
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