Behavioral Finance: The Psychology of Money

The field of behavioral finance has gained significant interest as more and more advice providers recognize that our own psychology plays a part in our own financial success.

We all have financial goals, and many of us struggle to meet them. It is easy to blame this on a lack of money, the stock market, or other factors, but in reality, our behavior and choices are often the biggest culprits.

What is Behavioral Finance?

Behavioral finance is the study of the influence of psychology and how it can affect market outcomes. It focuses on the fact that humans are not always realistic, don't always practice restraint on their actions, and are influenced by their own beliefs and preferences, which leads to their decisions being flawed.

A Comparison of Traditional Finance Theory and Behavioral Finance Theory:

Traditional finance theory makes assumptions in its models that people/investors are rational actors, meaning they are free from being influenced by emotion or the effects of social relations or culture. In addition, it takes for granted that markets are efficient, and firms are impartial and adept in bringing in a profit. Behavioral finance pushes back against each of the beliefs.

*Investors referees to people making their own financial decisions

Behavioral Finance Awareness

Behavioral finance can be evaluated from different perspectives. The study of behavioral finance can explain why an individual makes a particular financial decision and how their choices may affect markets. Remember, behavioral finance theory assumes that investors or financial participants are not perfectly rational, have limits to their self-control, and are influenced by their emotions, assumptions, and perceptions. And, these biases and irrational behaviors can have significant costs.

Behavioral Finance Concepts

While the field of behavioral finance is broad and complicated, there are several concepts that most frequently impact success with money. There are five main concepts:

• Mental Accounting: The inclination for people to allocate money for specific functions. One example of this is treating your IRS refund like winning the lottery. It is not – it is actually your own money coming back to you.
• Herd Behavior: Most of us are familiar with herd mentality – a tendency to follow or mirror what others are doing. In the behavioral finance context, it applies to those that tend to copy the financial behaviors of what other investors are doing without any reason. For example, investors can become caught up in buying or selling off large amounts of a specific stock because they heard or saw that "everyone" was doing it.
• Emotional Gap: Refers to decisions made while experiencing emotional strains, including stress, anger, anxiety, fear, or excitement. Our current mood can take our decision-making ability off-track from rational thinking. Not surprisingly, emotions are a central factor in why people do not engage in rational decision-making.
• Anchoring: Occurs when someone relies too much on the first or limited information that we have access to when they are choosing or making a decision. For example, let's say you see a pair of shoes that costs $1,000, then you see another pair of shoes priced at $100 – most of us are apt to view the second set of shoes as cheap. However, if you had never seen the first pair of shoes, you would probably not view them as inexpensive. Thus, the anchor – the first price you saw – improperly skews your opinion.
• Self-Attribution: Pertains to the tendency to make choices based on overconfidence in one's own skill or knowledge. To put it another way, an individual chooses how to attribute the cause of an outcome based on what makes them look best. One example is that people typically pay off debt more than they tend to save. To combat this tendency, start using automatic bill pay to not only pay your mortgage, car loan, or bills but also to save. Start by paying yourself today, when you use the power of automatic draft to save your money.

Common Biases in Behavioral Finance

When you delve a little deeper, behavioral finance seeks to understand the impact personal bias and tendencies have on investors. Behavioral biases often lead people to make illogical or harmful choices around money. Common biases include:

• Confirmation Bias: This tendency happens when individuals seek out information that aligns with their existing beliefs and ignore or overlook information that contradicts it, creating a self-reinforcing loop.
• Experiential Bias: This common bias occurs when an investor's memory of recent events creates a preference or causes them to think that this event is very likely to happen again. You don't have to look too far back to find an example. For instance, the financial crisis of 2008-2009 drove many investors to exit the stock market.
• Loss Aversion: Investors are so fearful of losses that they emphasize avoiding a loss than they put on making strides financially in this tendency. Research has shown that investors feel the pain of a loss more than twice as acutely as they feel the delight in making a profit.
• Familiarity Bias: This bias occurs when investors invest in what they know, like domestic companies or locally owned investments. Accordingly, one's assets are not diversified over various sectors and types, which can lessen risk. Likewise, people tend to invest in companies, areas, things, etc., with which they have a higher familiarity.

How Does Being Aware of Behavioral Finance Help You?

When you understand how and when people may stray from rational decision-making and expectations, the study of behavioral finance can provide a model to help individuals make better, more rational decisions pertaining to their money and finances.

Overcoming Behavioral Finance Issues

Is it possible to avoid or remain unmoved by your financial biases? Not really, at least not entirely. However, knowing that behavioral tendencies like these exist will help some. Here are a few other tips:

• Create a long-term financial plan to help keep distracting emotions from affecting your financial choices.
• Because losses often hurt more than gains make us feel happy, emphasize the negative. For example, say to yourself that "I am saving money to avoid debt and bad budgeting" instead of "I am creating a nest egg for my future."
• Track the decisions you have made about money and why you made them. Then, after a year, revisit what you did to see how much indecision you had and where you went wrong. By doing this, you may prevent your overconfidence in future money decisions.
• Get out of your comfort zone. Meaning if everyone around you is thinking and doing the same thing around investments, open yourself up to new and opposing views and strategies. Now, it is essential to be mindful that the opposing views may not be correct, but opening yourself up may help you distinguish between just following the crowd and following through with a financial choice based on research and understanding.
• Remember, money is interchangeable. So if you realize you have additional funds that you didn't expect, take the time to determine where they can do the most good in your financial picture.

The Financial Takeaway

Behavioral finance attempts to measure misguided moves and decisions people make with their finances. Many of these financial behavioral biases are intrinsic in how someone thinks, feels, and processes information. However, there are ways for the investor to try to resist them. Several time-tested methods to improve the way you make decisions about your money include:

• Developing a system of accountability
• Reframing or redefining wins and losses
• Staying away from groupthink (following the herd)

If you feel that your biases or preferences are clouding your decisions with money, reach out to one of our advisors. Spaugh Dameron Tenny helps dentists and physicians across the U.S. with holistic financial planning services.

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