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Invested Interests

Sara Glaz

Behavioral finance seeks to understand how we make our most important investment decisions — and how we can avoid making the worst ones.

Wednesday, February 25, 2015

“Hey, Dovid. It’s Menashe. I need the $25,000 by this afternoon. Avi Plotsker — the big gvir from Brooklyn — has $1 million in this deal as well. If you pass this up, you’re crazy. Trust me. I had to pull some major strings to get you in, so don’t mess it up.” Click. Dovid and Menashe had been friends for years. Dovid, an attorney by profession, was also a pretty savvy investor. Even though Dovid felt that Menashe’s newest deal didn’t sound so great, Dovid had done his due diligence — he looked at the contract and was even presented with a brokerage account showing a large sum of money. Unfortunately, unbeknownst to Dovid, the contract was a fake, the statement was doctored up, andAviPlotsker had no idea that Menashe even existed. Dovid was about to be scammed. While most people think it’s Madoff, Ponzi, or bad luck that causes financial loss, as often as not, we only have ourselves to blame. In fact, a relatively new field called behavioral finance uses psychology to help understand why people make their particular decisions and how those choices might be improved. Using behavioral finance, the averageJoe might be able to avoid typical investing pitfalls, like a tendency to be overconfident, to misuse intuition, and to not recognize emotions that can wreak havoc on our financial portfolios. “Dovid,” and all of us, can get richer just by being smarter about how and when we decide to spend our money. At the core of behavioral finance is the idea of “two minds,” the intuitive and the reflective. The intuitive mind is responsible for forming rapid judgments while the reflective mind processes slowly and analytically. For example, the intuitive mind might tell us to invest in the retail giant Target because it’s a great store and is always packed with customers. Yet, our reflective mind says: “Wait a minute. What’s Target’s profit-to-earnings ratio? And how do the company’s current assets compare to its liabilities?”Dr.DanielKahneman, a 2002 Nobel Prize winner in economics and one of the leading experts in behavioral finance, found that most people’s decisions are products of the intuitive mind, and are usually accepted as valid by the reflective mind, unless they are blatantly wrong. While the intuitive mind is sometimes correct, it can oftentimes make mistakes. For example, just because Target always has long lines doesn’t mean that it’s necessarily making a profit or that its stock price will rise. In fact, it’s the errors of the intuitive mind, along with failures of the reflective mind (to stop the more powerful intuitive mind) that most interest behavioral finance academics. 

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