Thursday, August 19, 2010

Behavioral Finance for Gen Y: Part 1

Today is the first part in a series of posts where I'm going to talk about behavioral finance for Gen Y, and then highlight certain investing biases that are especially prevalent among Gen Y investors. If you really take time to think about the behavior I will discuss and to understand the biases inherent in the mindset of most all investors, you will save yourself plenty of money and aggravation as you get older! 

First, I need to give a brief definition of behavioral finance, the study through which all investing biases flow from. In its purest form, behavioral finance is the study of how human emotions, interactions, and behavior all impact investment and financial decisions. Basically, the idea is that the human element, particularly our emotions and how we think and process information, plays a large part in impacting investment decisions.

Proof of this is readily available.

An Example of the Human Element in Investing

You've owned a stock for 5 years and during that time, it's gone up a split-adjusted 1,000% (hey, we can dream)! Now, the rational thing to do would be to evaluate your overall financial situation and if it warrants so, sell some of your holding and invest it elsewhere. Instead, what many investors tend to do (and it's not only Gen Y's who are guilty of this) is "fall in love with their stock".

In essence, we attribute the 1,000% price jump to our skill in stock picking and it pains us to sell the stock because we believe its success lends credence to our intelligence and superior stock picking skills. Before you say to yourself something to the effect of, "Well, I researched the stock and loved its fundamentals so I judged it to be a great investment", consider this scenario instead: 

Over the 5 year holding period, your stock is down 99% and the company is on the verge of bankruptcy. What do you think about your stock picking skills in this scenario? If you're like most investors, you'll probably blame bad luck for the extreme drop in stock price! This is what's termed a self-serving bias because you believe your stock picking skill led you to buy a big winner, but if it turns out to be a loser, you'll blame bad luck.

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