Behavioral Finance

Behavioral Finance

January 15, 2024

“Everyone has a plan until they get punched in the mouth.” -Mike Tyson


On the surface, it would seem insane to relate Mike Tyson and your investment portfolio. Over the last decade and a half, the investing masses experienced positive returns on their portfolio every year. I’d wager most didn’t even consider that the market could and would experience periods of prolonged volatility—the proverbial punch in the face. It’s easy to put a plan in place when the world is at peace and markets are on the upswing. That said, it’s hard to stay committed when the fog of [insert unthinkable threat here] sets in and the markets become unwieldy and turbulent. Behavioral finance is the study of these psychological factors that can make or break your performance.   

What is Behavioral Finance?

Behavioral finance is the study of how psychological biases and emotions impact an investor’s decision-making process. Reams of historical data be damned – it’s exceedingly difficult to react in a rationale way when confronted with challenging decisions. Investors struggle with their own biases and self-control when making financial decisions. 

The 7 most Common Behavioral Finance Mistakes

1. The Behavior Gap

The charts don’t lie. It cannot be disputed that while the market experiences short-term volatility, it historically always goes up when zoomed out to a longer period of time. As we know, past performance is not indicative of future results. Perhaps this time is different, right?

In the book The Psychology of Money, Morgan Housel crisply condenses his thesis, “good investing is not necessarily about making good decisions. It’s about consistently not screwing up.” When the market experiences periods of volatility, it is all too common for an investor to allow their emotions to get the best of them. After all, our caveman brains are physiologically predisposed to attempt to avoid loss more than they are to appreciate a gain. Our brains actually process the threat as existential. A study by Stanford professor, Brian Knutson found that once an investor experienced an unexpected loss, the pain center in the brain became aroused and future decisions became much more irrational.

An investor opting to ignore their buy and hold investment strategy and selling out of their investment(s) can negatively impact their overall returns. Carl Richards refers to this difference between an “investment return” and an “investor return” the Behavior Gap (behaviorgap.com), as illustrated.


When markets are trending in an upward direction, investors often experience feelings of euphoria. A job well done! I can’t believe how easy this is! Look how much money I am making! Why isn’t everyone doing this? I must be more intelligent than the masses… It’s alluring to add to portfolios as gains increase. A feeling of greed and almost invincibility can take over. These feelings typically disappear when the market has a dramatic pullback. I knew I should have sold! I can’t believe I did this!What am I going to do? Fear leads to panic selling. An investor should rely on their investment plan, avoiding rash decisions. You cannot time the market so it’s essential to stay invested. This resolve is what separates unskilled and undisciplined investors from their money… Richards describes this feeling perfectly in this illustration.


2. Allowing negative information to affect your investment philosophy

As the old saying about the media goes: if it bleeds it leads. Bad news always gets the media focus in general, and on social media in particular. Our attention is the currency that social media companies thrive on. In other words, the more of a rise they can achieve, the better for their bottom line. Given the 24-hour news cycle we find ourselves in, it is all too easy to become distracted by the crisis du jour. Will the current events have an impact on your portfolio? Perhaps in the short term, but crises have a way of working themselves out over a longer period of time. This too shall pass, right? There is typically no need to make a drastic change in a proper portfolio strategy—no matter what your appetite is for risk—based off the news story of the day.

Another media strategy is to bombard the audience with predictions and prognostications. These are particularly amusing as I’m perpetually struck by the thought “If they knew what was going to happen in the markets, why wouldn’t they just spend all of their time managing their own would-be fortune?” Dr. Daniel Crosby is an expert in the world of Behavioral Finance and author of the book The Behavioral Investor. He was recently on Thomas Kopelman’s podcast discussing this very topic. A study was done that examined 70,000 analysts estimates on how the stock market would perform in the future. Their predictions were correct a measly 1 in 170 times on average. Yet how many people make their investment decisions based on analyst predictions?

3. Checking accounts too often 

An underrated strategy for keeping emotions in check with investments is to stop checking accounts on a frequent basis. In his book Behavioral Investment Management: An Efficient Alternative to Modern Portfolio Theory, Greg Davies analyzed the effect of checking a portfolio on varying timeframes. Davies’ research found that investors who check their account every single day will have a much greater likelihood of making decisions that incur actual losses as they’ll witness reduced portfolio value ~ 41% of the time. This, contrasted by Investors who review performance every 5 years with a ~ 12% chance of reduced value at the time review.  

4. Being too conservative

As humans, we are genetically predisposed to feel the pains of loss roughly twice as much as we feel the joys of gains. It actually a survival mechanism gone awry. Understandably, this leads investors to skew their portfolios to the conservative side. Interestingly, being too conservative with an investment portfolio can be just as costly as being too aggressive. The prevailing sentiment goes something like this - as long as my portfolio balance doesn’t go down, or goes down as little as possible vs. the market, I’m doing well. While it may make you feel warm and safe, the truth is you are actually silently losing money. From 2012 through 2022, the average rate of return of a cash instrument, say a money market for example, was 0.75%. During that same period, inflation grew at 3.75%. In other words, while the money market investor didn’t see a decrease in their invested balance, they actually lost significant value (read: purchasing power) on those dollars. Had that same investor put their money into a 60% stock, 40% bond portfolio, which is seen as slightly more aggressive than middle of the road, a 12.5% return would’ve been realized over the same period.

5. Overconfidence

Everyone has a story about a friend or in-law that made a grand slam stock purchase. Perhaps they bought Apple in 2009 for $5/share and sold it in 2020 for $150/share. These people chalk up such success to investment prowess rather than fortunate timing, and yes, a healthy dose of good luck. Such investors often believe this grand slam result is not only easily repeatable, but definitely going to happen again with their next pick. I recently had the pleasure of chatting with someone who experienced such a success. When asked about future investments, the response was “Oh, I’ll just do it again, probably by picking an artificial intelligence company.” This type of overconfidence leads to making terrible investment decisions. Going “all-in” on one stick and ignoring proper diversification often leads to losses when the strategy backfires. If you want to gamble, go to Las Vegas.   

6. Selling out of the market and waiting until things calm down before reengaging

Again, as a survival mechanism, humans are physiologically predisposed to feel the pain of loss roughly twice as much as they feel the joy of gain. There are considerably more words in most languages to describe negative vs. positive things. The nuance is functional. During periods of market volatility, a common mindset investors routinely employ is to sell at a loss, awaiting calmer periods to reinvest. The problem with this strategy is that it requires the investor to be correct twice. They have to sell at the correct time and get back in before the market begins its rebound. Timing the market at any point is practically impossible. Now try to do it twice in succession… This is illustrated by the J.P. Morgan analysis of the Impact of Being out of the Market. The chart is predicated on a hypothetical $10K investment in the S&P 500 from January 1st, 2003, to December 31st, 2022. By staying fully invested over that 20-year period, the annual rate of return is 9.8% per year. If the investor decided to sit on the sidelines during periods of volatility and missed just the 10 best days in the market over that 20-year period, their return drops to just 5.6% per year. If they miss just the 30 best days, the return drops to .8% per year. Missing the 60 best days over a 20-year period drops the return to a -4.2% per year rate of return. The power of staying invested simply cannot be understated.

7. Holding onto an investment for too long

Investors are guilty of hanging on to investments for too long primarily for two reasons: they have made so much money on the investment that they have fallen in love with it and can’t bear to part ways, or, they have lost so much in the investment that they are desperately hoping for it to come back.

Success of a particular investment can be incredibly rewarding for an investor—assuming they know when to let it go. Divesting a winning investment selection can be extremely painful because there is a real sense of FOMO—fear of missing out—the possibility that the investment will keep going up. An alternate view is to consider that the investment did extremely well and there is a need to take some of the winnings off the table and reallocate them elsewhere. Just because you make a profit on a particular strategy doesn’t mean you have to liquidate and hang onto that cash; those dollars should be deployed elsewhere to enjoy gains in other areas of the market. Should there be losses, the tax loss harvesting is prudent. There are seemingly endless examples of companies/stocks that seemingly couldn’t lose...until they did!

What should you do?

Remember, humans are physiological predisposed to feel pain when we lose money; so the first step is to acknowledge that it is virtually impossible to remove all emotion from financial decisions. Secondly, taking the time to create a Personal Investment Policy Statement that outlines the following.

  • Risk Tolerance—are you more motivated by your account going up, or by it not going down? When the market goes through periods of volatility, are you going to lose sleep and experience marked discomfort? How much loss is too much?
  • Asset Allocation Strategy: Simply put, how much money you leave in cash instruments, bonds, and other investments. Any sound asset allocation strategy should have money keep entirely on the sidelines in an interest-bearing savings or market account. Perhaps the most important element of asset allocation is the split ratio between stocks and bonds - much of the volatility in a portfolio will be a result of this decision.
  • Time Horizon—Do you need the money for anything anytime soon? If your runway in less than 2-3 years, be sure to choose channels that bear guaranteed returns like fixed income.

When the market goes through periods of volatility, pull out the Investment Policy Statement and remind yourself of the strategic approach you formulated and why. The IPS can act as a beacon of light during a very tumultuous period and save you from making irrational decisions you’ll likely regret in the future.


Great resources on Behavioral Investing if you'd like to learn more

Carl Richards at Thebehaviorgap.com

Dr. Daniel Crosby’s books The Behavioral Investor and The Laws of Wealth

Morgan Housel’s book The Psychology of Money

RiversEdge Advisors, LLC is a registered investment adviser.  Registration does not imply a certain level of skill or training. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Investments involve risk and, unless otherwise stated, are not guaranteed.  Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.