By John Spoto
Last time, we introduced the concept of behavioral finance, a relatively new field attracting the attention of mainstream investors over the last 20 years.
Behavioral finance is the area of economics that studies how the financial decisions we make are influenced by factors beyond a purely logical analysis of the situations we face. Specifically, it studies how our biases and emotions affect the manner and quality of our decision-making.
Much of the research conducted on how the brain operates suggests that the left and right sides of our brain perform different and specific functions and determine much of our personality traits and problem-solving styles. In general, the left hemisphere of our brain is primarily responsible for fact-gathering, logical thinking and analysis. The right side, on the other hand, is more visual and creative and determines how we act on our feelings and emotions.
Most experts agree that while both sides of the brain are involved in almost every human activity, most of us seem to have a dominant or preferred side that we tend to rely on almost automatically. In other words, while many people are adept at using both styles of thinking to make decisions, most prefer one style over the other.
What does this have to do with how we make important financial decisions, like saving for retirement, managing our investments and paying for our kids’ education? More than you may think.
The evidence suggests that there is often a significant gap, especially when we are under stress, between how we should behave to get the results we want versus how we actually behave. Rather than applying both sides of our brain when confronting an important challenge, we often abandon our rational thinking and let our emotions take over. Unfortunately, the consequences of this behavior gap can be hundreds of thousands of dollars of lost wealth over our lifetimes and, more importantly, the regret of not achieving some of our most important goals.
Other studies, however, indicate that logic and reason alone are not enough. It is a combination of intuition, emotions and reason that yield the best decisions.
Although behavioral finance is still primarily an academic field dominated by scientific research, it is important to see how we might be able to apply the theory to the real-world situations we encounter. Identifying and understanding those aspects of behavioral finance relevant to our financial lives can help us make more sensible decisions and achieve better results for our families and ourselves.
In the next column, we’ll talk about how investors sabotage themselves.
This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.
John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com.