While behavioral finance hasn’t found ways to improve investment returns, it does provide us with ways to improve investor returns. Richard Thaler and Cass Sunstein have written a wonderful book called Nudge using the insights gained from studies on human behavior. The book’s descriptions of behavioral mistakes and how to help people avoid them can be applied to investing as well as everyday life. Over the next few posts, we’ll take a look at some of the valuable investing lessons taught by this book. Consider the following:
The authors describe a mistake called “availability bias.” For example, they note that people assess the likelihood of risks by asking how readily examples come to mind. People are much more concerned about a risk when they can easily think of relevant examples than if they can’t. Thaler and Sunstein note that because homicides are more familiar than suicides, people tend to wrongly believe more people die from homicide. If you have a personal experience with an earthquake, you’re more likely to believe an earthquake is likely than if you just read about one.
Regarding investing, advisors can appropriately increase investors’ level of fear during good times by showing them that history is filled with unexpected events that led to bear markets. During bear markets, they can help prop up investor confidence by reminding them of similar situations when everything eventually turned out well.
On Wednesday, we’ll see how an advisor can help investors have the courage (in bear markets) and discipline (in bull markets) needed to rebalance their portfolios.
Follow the series:
- Part one: How to Avoid Availability Bias
- Part two: How Framing a Question Can Change Your Answer
- Part three: Investors Can Be Nudged to Do the Right Thing
