What Is Behavioral Finance? And How It Impacts Your Money Everyday
When it comes to money, it's not just about the decisions you make—why you make them plays an equally critical role in developing healthy financial habits that last a lifetime.
There's a science to your "why," and that’s what we like to call “behavioral finance.”
What is behavioral finance, and why is it important? Let’s find out.
Understanding Behavioral Finance
Behavioral finance is the fusion of psychology and money—it examines psychological influences on money and money habits. More so, it’s the study of psychological consequences on investors and financial markets.
Why do even the most experienced investors often buy too late or sell too soon? The effect of behavioral finance biases leads us to sometimes make illogical investment decisions.
Let’s face it, we aren't always rational and don't always make the "logically" best choice. Sometimes we invest so we "don't miss out," and other times, our biases (like fear of a downturn) keep us from investing the way we need to reach our goals.
Think about it this way: It’s been shown that companies with 401(k) plans that auto-enrolled employees in plans sent retirement contributions skyrocketing.
Why is that?
Because people are less willing to "opt-In" than they are to "opt-out." Understanding financial behavior and biases can help people make more rational moves with their money and set up a strong financial path to success.
Top 6 Money Biases That Influence Your Habits
When we make poor financial decisions, it’s often due to some sort of bias. Understanding the cognitive biases that have been identified by those who have studied behavioral finance can help you more clearly understand the “why” behind your financial decisions. There are six core cognitive biases that affect our financial decisions:
1. Loss aversion
Loss aversion is one of the most powerful emotional biases. It refers to the desire to avoid any and all risk that could result in a loss, even a minuscule one.
A consequence of loss aversion is that people don’t want to take any risk on their investments. To combat this, it’s important to tap into your risk capacity or how much risk you are willing to take to reach your goals.
For example, you likely won’t be able to sustain your retirement lifestyle by squirreling your money in savings accounts and CDs. The returns are simply too low. You need your money to take advantage of compounding interest and keep pace with inflation, making long term investing in the stock market and ignoring short-term random fluctuations an excellent medium.
2. Endowment effect
The deep desire to avoid losses can result in the endowment effect, which is when people value an item more highly once they own it.
You might not think the artwork hanging on your friend’s wall is all that special until you acquire a stunning piece you can’t get enough of.
This mindset leaves people with the dreadful thought that letting go of something they own is a complete loss, even if doing so would result in a higher gain. You might feel this way when you rebalance your portfolio or sell any equity in your company.
Once we become emotionally invested in something, it becomes more difficult to let go. Instead of tying your emotions to your investment decisions, try to look at how your short-term choices impact your long-term outlook.
3. Fear of missing out
Ever heard of the acronym FOMO? The fear of missing out doesn’t just apply to social decisions but to financial ones as well.
It’s far too easy to blindly follow friends, family members, or people on social media who have found the next “big break” in investments without considering how it fits into your plan. A lot of advertising is based precisely on this bias.
Or maybe you missed out on a really great investment before, and you don’t want that to happen again—we get it—but just because everyone is doing something doesn’t mean it’s right for you.
Cryptocurrency is a good example.
There are numerous iterations of coins and digital currency to invest in. If you put money down for every single one, you wouldn’t set yourself up to reach your goals. Instead, you’d be sitting on a pile of NFTs, micro pieces of Bitcoin and Ethereum, and likely strays of several others with no strategy to hold them together.
Your investments have the biggest chance of success when there’s a clear strategy and lifetime plan for achievement. Instead of letting FOMO be in the driver’s seat, let your long-term goals, values, and vision, take the lead.
Talk with your financial advisor and make sure that an investment or other financial strategy is suitable for you.
4. Sunk cost fallacy
The sunk cost fallacy occurs when you invest more money in a losing project because of the previous investments you’ve already put into that project.
It’s like continuing to invest in a car that breaks down every couple of months. You’ve already invested $5,000 in repairs, so you don’t want to give up on it, even though buying a new car would be better in the long run.
The bottom line? Don’t dwell on one bad decision or outcome. Make a plan to get through it, set a goal, and work toward that goal.
5. Status quo bias
Status quo bias refers to when we essentially do nothing to avoid loss. From an investing sense, this would mean that you hold onto a stock or investment that has lost value because you don’t want to take a loss.
The purchase price of the stock becomes our reference point for all decisions when in reality, we need to think rationally about the cost and how it compares to future prices and dividends.
You may have to sell an investment or two now to open up different opportunities down the line. For example, say you sell some assets at a loss. Doing so enables you to take advantage of tax-loss harvesting, and you end up canceling out some of your more substantial gains throughout the year—take a smaller loss to make a bigger win.
6. Confirmation bias
Confirmation bias is when people make decisions based on familiarity. It keeps us from conducting more in-depth research and doing proper due diligence before making a decision.
The best way to make an informed decision is to ask questions and collaborate with your financial advisor.
Why Knowing Your Biases Helps You In the Long Run
Being attuned to your thoughts, attitudes, and beliefs about money can help you be more intentional with your actions. You'll have more agency and confidence to make the best choices that align with your goals and values.
If you read through the cognitive biases and realized that you fell into one or more categories, that’s okay. Nearly everyone has - welcome to the human race! But knowledge is power and by understanding your own cognitive biases, know that you also have the power to change. And we’re here to make that path to a better financial future a reality.
We’ll focus on the finances so you can focus on what matters most to you. Get in touch with our team at Pro Wealth today.