The Stewardship of Wealth: Successful Private Wealth Management for Investors and Their Advisors, + Website

Behavioral Finance: Are We Hard-Wired for Failure?

The findings of behavioral finance can make us feel that as investors we are doomed to fail. But human beings aren't automatons—we can become more self-aware and learn from our mistakes. This portion of the chapter briefly discusses some common behavioral failures and what we might do about them.⁹

We don't have to observe investor behavior for very long before concluding that human beings are hard-wired for investment failure. Large fortunes tend to disappear entirely in three generations. During bull markets investors lose all sense of perspective and load up on increasingly risky equities, as though prices could never go down. During bear markets investors give in to despair, selling out near the bottom, apparently convinced that equity prices are going to zero. Investors chase returns, piling into whatever sector or manager is hot, ignoring research showing that return-chasing behavior always ends in tears.

There is even an entire field of study—behavioral finance—devoted to the detailed analysis of how and why investors fail. Exotic-sounding concepts like “loss aversion” are really just academic jargon for investor behavior we see every day. These so-called “cognitive biases” lead us to behave in ways that are irrational, that is, that lead us into taking actions that are against our own interests.

It's very important for investors to recognize that we are optimized for wealth destruction, especially at inflection points in ...