Behavioral Finance and Your Portfolio

2Introduction to Behavioral Biases

Nothing in life is quite as important as you think it is while you're thinking about it.

—Daniel Kahneman

Introduction

In order to create your best portfolio, it is essential that you obtain an understanding of the irrational behaviors that you have—or be able to recognize the biases of others that may be involved in your investment decision-making process. Numerous research studies have shown that when people are faced with complex decision-making problems that demand substantial time and cognitive decision-making requirements, they have difficulty devising a rational approach to developing and analyzing a proper course of action. This problem is exacerbated by the fact that many consumers need to contend with a potential overload of information to process. Have you walked down the shampoo aisle lately? Way too many choices—how do you pick? And this is one of the easier decisions we face! When it comes to our money, it becomes even more complicated. For more meaningful decisions, people don't systematically describe problems, record necessary data, and/or synthesize information to create rules for making decisions, which is really the best way to make complex decisions. Instead, people usually follow a more subjective path of reasoning to determine a course of action consistent with their desired outcome or general preferences.

Individuals make decisions, although typically suboptimal ones, by simplifying the choices presented to them, ...