Behavioral Finance
Panic is reacting to news and taking actions that might not be best for long-term strategies. If you avoided reacting with actions, you are to be congratulated.
I recognize that there are short-term feelings and fears and that’s very understandable; we have them too! But we have strong beliefs that the best way to invest for the long-term is to think about things in the long-term. Short term ups and downs often are mere noise.
There’s a concept in finance called behavioral finance. I thought it might be interesting to learn now that things seem to be calming down (at least just a little bit in the markets). Given how often we tend to react in times of uncertainty on an emotional basis, it might be enlightening.
We are not out of the woods yet. You’re still going to see lots of volatility. Let’s not get too euphoric. They’re still plenty of uncertainty in the markets and the economy and we will continue to monitor conditions and make adjustments as needed.
Note below the following information on behavioral finance. I think you will find it interesting.
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“For decades, psychologists and sociologists have pushed back against the theories of mainstream finance and economics, arguing that human beings are not rational utility-maximizing actors and that markets are not efficient in the real world. The field of behavioral economics gained momentum in the late 1970s to address these issues, accumulating a wide swath of cases when people systematically behave "irrationally." The application of behavioral economics to the world of finance is known, unsurprisingly, as behavioral finance.
From this perspective, it's not difficult to imagine the stock market as a person: It has mood swings (and price swings) that can turn on a dime from irritable to euphoric; it can overreact hastily one day and make amends the next. But can human behavior really help us understand financial matters? Does analyzing the mood of the market provide us with any hands-on strategies? Behavioral finance theorists suggest that it can.
Behavioral finance is a subfield of behavioral economics, which argues that when making financial decisions like investing people are not nearly as rational as traditional finance theory predicts. For investors who are curious about how emotions and biases drive share prices, behavioral finance offers some interesting descriptions and explanations.
The idea that psychology drives stock market movements flies in the face of established theories that advocate the notion that financial markets are efficient. Proponents of the efficient market hypothesis (EMH), for instance, claim that any new information relevant to a company's value is quickly priced by the market. As a result, future price moves are random because all available (public and some non-public) information is already discounted in current values.
However, for anyone who has been through the Internet bubble and the subsequent crash, the efficient market theory is pretty hard to swallow. Behaviorists explain that, rather than being anomalies, irrational behavior is commonplace. In fact, researchers have regularly reproduced examples of irrational behavior outside of finance using very simple experiments.
"It's understated to say that financial health affects mental and physical health and vice versa. It's just a circular thing that happens," said Dr. Carolyn McClanahan, founder & director of Financial Planning at Life Planning Partners Inc. "When people are under stress because of finances, they release chemicals called catecholamines. I think people have heard of things like epinephrine and stuff like that, that kind of put your whole body on fire. So that affects your mental health, affects your ability to think. It affects your physical health, wears you out, makes you tired, you can't sleep. And then once you can't sleep, you start to have bad behaviors to deal with that."
What does behavioral finance tell us?
Behavioral finance helps us understand how financial decisions around things like investments, payments, risk, and personal debt, are greatly influenced by human emotion, biases, and cognitive limitations of the mind in processing and responding to information.
How does behavioral finance differ from mainstream financial theory?
Mainstream theory, on the other hand, makes the assumptions in its models that people are rational actors, that they are free from emotion or the effects of culture and social relations, and that people are self-interested utility maximizers. It also assumes, by extension, that markets are efficient and firms are rational profit-maximizing organizations. Behavioral finance counters each of these assumptions.
How does knowing about behavioral finance help?
By understanding how and when people deviate from rational expectations, behavioral finance provides a blueprint to help us make better, more rational decisions when it comes to financial matters.”
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