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Why We Do Stupid Things With Money: A Three-Part Crash Course in Behavioral Finance - Part I

January 04, 2021

Part 1

We've all done it - made a poor decision about money. Maybe it was because we didn't know any better. Maybe it was because we got some bad advice. Or maybe it was because we fell prey to a cognitive error or emotional bias. The software that operates our brains is rather outdated, written thousands of years ago to help us survive in a very different type of world. Our brains have yet to catch up to the realities of our modern world. That prehistoric lizard brain we all have deep inside us can really muck up our thinking. Nearly every investor will have to face down their own lizard brain at some point during their financial lives.

The field of study that addresses these errors and biases is known as Behavioral Finance. Behavioral Finance falls under the larger field of Behavioral Economics and posits that our cognitive errors and emotions can impact our behavior as investors. Often, that impact is negative.

The Rational Investor

For decades, the advice given to individuals about how to invest was underpinned by Modern Portfolio Theory. (I won't bore you with the details on exactly what MPT is, but if you're curious, you can learn more here.) One of the most important assumptions in MPT is that investors are rational - that is to say, they make decisions based only on facts, data, and numbers rather than emotions or flawed thinking. The problem is, we know that investors are rarely perfectly rational.

Think back to March 2020. Even professionals like Baird's own Mike Antonelli had trouble keeping it together. If a highly trained and experienced professional can lose his nerve and fall victim to irrational thinking, what would make you any less vulnerable?

The first step is understanding our own flaws.

Come back next week for Part II.

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