Behave Yourself: What is Behavioral Finance and Why is it Important?
Hello, my name is Ed and I am currently a senior in college with a passion for behavioral finance. I am creating this blog with the hope that it will help to educate people about the importance of behavioral finance as well as promote interest in the field as a whole. In today’s piece I will discuss what behavioral finance is and why it is important.
The first time I had ever heard of behavioral finance was when I picked up a book called The Little Book of Behavioral Investing by James Montier. At first I was skeptical but as I read the first few pages the subject began to peek my interest. At that time I did not know how important psychology was to investing. I thought that you simply evaluated stocks to find those that looked favorable, purchased them, and watched your money grow.
Victor Ricciardi, a professor of Financial Management at Goucher College, defines behavioral finance as a theory that “attempts to explain and increase understanding of the reasoning patterns of investors, including the emotional processes involved and the degree to which they influence the decision-making process.” Simply stated this quote means that behavioral finance is a psychological analysis of investing patterns that considers the impact that emotion has on decision-making. This field is incredibly important because many investors fall prey to their own emotional pitfalls. Benjamin Graham, the famous value investor and mentor to Warren Buffet, said, “The investor’s chief problem – and even his worst enemy – is likely to be himself.”
Allow me a moment to tell you a quick story about my childhood (I promise it relates). When I was five years old I was infatuated with fire. Specifically, I was fascinated how fire, which was supposedly so hot, took so long to burn to the bottom of a candle. One day my curiosity got the best of me and I reached out and touched the fire thinking that it would not be hot at all since the candle burned so slowly. I burned my finger so badly that I had to put ice on it every night for a week. How does this story relate to behavioral finance you may ask? I have never met an investment professional who has never been burned by a poor investment decision. Behavioral finance is important because it allows us to evaluate our past decision making processes and the emotional biases we had and learn from our mistakes so that we can avoid being burned by the market.
I hope that this first blog post has sparked your interest in behavioral finance. My next post will begin to break down different aspects of the field and will specifically cover the two systems our brains use when making decisions.