Retirement Plan Investing
A growing field in economics and finance is "Behavioral Finance," a field of finance that proposes psychological-based theories to explain stock market movements. This differs from conventionally-accepted understandings of investing as a rational process in which investors allocate capital and make decisions based solely on risk/reward trade-off. The field of behavioral finance attempts to explain anomalies in the marketplace where traditional theories have failed. Below is a list of a few concepts that have been identified as contributing to irrational behavior and possible detrimental decision making.
Investors tend to "anchor" their thoughts to a reference point, even if that reference point doesn’t have any actual relevance to the decision at hand. This also delays the absorption of new information as it becomes available.
Mental accounting refers to the tendency for people to separate their money into different accounts based on a variety of subjective criteria, such as the source of money or the intent of each account. Instead of considering their portfolio in total , people think about each account differently, which can lead to less than optimal decision making.
An investor is more likely to look for information that supports their original decision instead of objectively looking at all of the facts and any contradictory information.
This occurs when an investor believes, after the fact, that an event was obvious and predictable at the time it was happening. This can be dangerous as it leads to investors having overconfidence in their future decision making.
This occurs when an individual believes that the outcome of a random event is affected by the past outcomes of the event, such as the a series of coin flips that come up one side or the other repeatedly. This can cause an investor to alter their predictions on the future, say the daily price of a security, based on past random events that have no effect.
The tendency for individuals to mimic the actions of a larger group. This can lead to bubbles in financial markets, as too many investors can move into the same trade.
Overconfident investors believe they are better than others at choosing the best stocks and best times to enter/exit a position, which leads to over trading, lower performance and higher transaction costs and tax consequences.
This occurs when one puts more emphasis on a piece of news than what is necessary or appropriate.
Every investor has been guilty of some or all of the above biases and mistakes above. A recognition and awareness of these psychological pitfalls should positively impact your decision making and improve investment returns.