As you probably know, this year is an election year. For the next 12 months, you and I will be bombarded with scathing television ads, annoying late-night calls from pollsters, and likely more and more bizarre comments from candidates on both sides. Our political system has evolved into a pageant of sorts where hopeful wannabes increasingly play into voter’s emotions and seem to enjoy creating media frenzies. This stands in stark contrast to a hypothetical individual known as the rational economic man.
The rational economic man first appeared in the late 19th century and has been referred to by a variety of economists and economic theories since then. The rational economic man is, in many ways, the optimal nerd. The rational economic man makes decisions based on optimal utility (the greatest reward for the least amount of risk). He is perfectly rational, perfectly self-interested, and he has all of the information there is to have. When the rational economic man decides it’s time to buy a car, he really does buy the best one on the market for the best price. He does all of this through the use of mathematical equations that allow him to calculate the best option at all times. He is a nerd after all.
It is my personal opinion that most of us fall somewhere in between the two. I for one do not make complex mathematical calculations when deciding what to have for breakfast. I also try not to make dramatic, sweeping statements that may or may not be true. For one, it’s an easy way to offend individuals and lose friends, but leaning towards emotional responses is also one of the easiest ways to lose money when it comes to the financial markets.
The rational economic man was dreamed up to help economists make sense of the way the markets work. He is part of the broader topic of traditional finance, which covers most of the theories and equations that the study of finance has historically been based on. However, recently the field of behavioral finance has begun to challenge traditional finance, arguing that most individuals aren’t perfectly rational and that the markets don’t actually operate under the assumption that all of the information is available to everyone. If we’ve seen anything in recent weeks, it’s that things like fear and greed do play a role in the market and emotions cannot simply be ignored when it comes to investing. You can’t help but feel the way you feel; however, when emotions begin to inform our investing decisions, we are likely to find ourselves making poor decisions. Emotions are what lead us to sell out at the bottom or to assume that because we like a company’s product, we should also purchase that company’s stock. But, it’s also silly to assume that we can completely remove emotions from the markets. As long as people are behind buys and sells, the markets will rise and fall, in part, due to human behavior.
One of the key attributes of a quality advisor is someone who understands that who you are should play a role in how you invest. So often it seems the question is how would you like your account to be invested when in reality, the questions should be – what are your goals and what are your fears? As behavioral finance gains credibility, more and more research is popping up that shows us how to incorporate risk tolerances with investing and how to avoid unnecessary expenses from overtrading. Instead of trying to ignore the emotional aspect of investing, behavioral finance allows us to acknowledge it by offering tools such as questionnaires that help us identify our emotional weaknesses. In doing so, we put ourselves in a much better place to combat irrational decision making. In the coming months, I’ll be doing a periodic series of articles about the different aspects of behavioral finance and what they mean to us as investors. My goal will be to help us identify certain biases we have when it comes to the markets as well as help you understand some of the key underlying assumptions that the market is predicated on and where they fall short. You can make sure not to miss out by signing up for our weekly newsletter at the bottom of this page.