In our last blog entry we introduced the concept of behavioral finance which is a relatively new field that has been gaining importance over the last twenty years. Behavioral finance is the area of economics that studies how the financial decisions we make are influenced by factors beyond a purely logical analysis of the situations we face. Specifically it studies how our biases and emotions affect the manner and quality of our decision making.
Left and right brain
Much of the research conducted on how the brain operates suggests that the left and right sides of our brain perform different and specific functions and determine much of our personality traits and problem-solving styles. In general, the left hemisphere of our brain is primarily responsible for fact gathering, logical thinking and analysis. The right side on the other hand is more visual and creative and determines how we act on our feelings and emotions.
Most experts agree that while both sides of the brain are involved in almost every human activity, most people seem to have a dominant or preferred side that we tend to rely on almost automatically. In other words, while some people are adept at using both styles of thinking and making decisions, most have a preference for one style over the other.
The implications for our finances
What does all that have to do with how we make important financial decisions like saving for retirement, managing our investments and paying for our kids’ education? More than you may think. The evidence suggests that there is often a significant gap, especially when we are under stress, between how we should behave to get the results we want vs. how we actually behave. Rather than applying both sides of our brain when confronting an important challenge
we often abandon our rational thinking and let our emotions take over. Unfortunately the consequences of this behavior gap can be hundreds of thousands of dollars of lost wealth over our lifetimes and more importantly, the regret of not achieving some of our most important goals. Yet other studies indicate that logic and reason alone are not enough. It is the combination of intuition, emotions and reason that yield the best decisions.
Behavioral finance is interesting, but is still primarily an academic field dominated by scientific research filled with technical terms that are beyond the scope of these articles as well as my own expertise. My purpose in writing this series of articles is to demonstrate how we can apply the theory of behavioral finance to the real-world situations we encounter. Identifying and understanding those aspects of behavioral finance relevant to our own financial lives can help us make more sensible decisions and achieve better results for ourselves and our families.
In the next blog entry, we’ll talk about how investors sabotage themselves.