Understanding behavioral economics can help
investors stay the course

Behavioral economics is a relatively new field that resonates in the current economic climate. Researchers studying behavioral finance seek to identify emotions that can be detrimental to investors' long-term investment goals. For example, the panic or euphoria that accompanied recent market fluctuations may have made it difficult to stick to an investment plan. Understanding what drives investment behavior can help investors fight emotional urges and stay rational in difficult conditions.

There's an obvious benefit to uncovering the rationale behind investors' choices. You don't have to look farther than a best-seller list to surmise that behavioral finance has become a popular field of study. From veteran finance columnist Jason Zweig's Your Money & Your Brain: How the Science of Neuroeconomics Can Make You Rich, a study of the convergence of neuroscience, economics and psychology, to the hit Freakonomics by Stephen Dubner and Steven Levitt (more than 3 million copies sold and translated into 30 languages), people find that finance and psychology are interesting companions.

Understanding the principles of behavioral finance can help you take the emotion out of investing and ensure you follow your long-term investment plan. Some strategies.

• Avoid the "all or nothing" mentality. During extreme market volatility, it may be unsettling to do nothing. It may help you feel you're taking control of the situation to sell a small amount of equities, but you won't have acted irrationally.
• Stay away from information overload. Many 24-hour financial news networks feed on bad news. These shows are often trying to attract audiences by playing on one's emotions.
• Be clear about whether you're investing or trading. Don't apply the behavior of a trader to your investment portfolio. That's a ticket to an emotional roller coaster.
• Apply the 24-hour rule. Emotions can be the greatest enemy of the stock market investor. If you're tempted to make a rash decision to buy or sell, wait 24 hours. Give yourself time to settle down and see the bigger picture. Revisiting the issue a full day later may help you gain a calmer perspective.

Key to Behavioral Economics Terms
Why do investors act the way they do? Here's a sampling of behavioral finance principles:

Anchoring: Basing investing decisions on irrelevant statistics and figures rather than evaluating a stock based on the big picture.

Confirmation Bias: Looking for information that supports an investment decision rather than looking for both the pros and cons of an investment. Investors with this tendency are more likely to simply ignore contradictory information.

Gambler's Fallacy: Not understanding the laws of probability: just because 20 flipped coins land "heads" does not increase the likelihood of the 21st coin landing "tails." Similarly, a stock that has been going up does not mean it's more likely to go down.

Herd Behavior: Constantly buying and selling investments to follow the latest investment trend since "everyone else" is doing it.

Hindsight Bias: Thinking that an unpredictable event was, in hindsight, obvious. This bias can lead to another dangerous emotion: overconfidence.