By Shane Tenny, CFP®
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 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. This is illustrated by this fact:
“Brilliant Investments Will Not Overcome Inadequate Saving”
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 around money 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 that 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.
|Traditional Finance Theory||Behavioral Finance Theory|
|Includes the following beliefs||Traits of behavioral finance|
|-The market and investors are rational||-Investors are looked at as “normal,” not “rational”|
|-Investors care about practical features||-Investors are influenced by their own biases|
|-Investors have superb willpower||-Investors have limits to their self-control|
|-Investors are not thrown off by cognitive errors or information processing errors||-Investors can and will make a cognitive error that can lead to incorrect decisions|
*Investors refers to people making their own financial decisions
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 certain 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 the term 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: This 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.
Why Does Being Aware of Behavioral Finance Help?
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:
- Creating a long-term financial plan can help keep distracting emotions at bay
- 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.”
- Start tracking 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 dissenting 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 or a hot trend.
- 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 measures misguided moves and decisions people make with their money and finances. Many of these financial behavioral biases are intrinsic in how someone thinks, feels, and processes information. However, there are ways 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 wines and losses
- Staying away from groupthink (following the herd)
Shane Tenny, CFP®, is a partner at Spaugh Dameron Tenny, LLC, which has been providing comprehensive financial planning for clients across the U.S. for over 50 years. For more information, visit https://www.sdtplanning.com/
Securities, investment advisory and financial planning services offered through qualified Registered Representatives of MML Investors Services, LLC. Member SIPC. Supervisory office: 4350 Congress Street, Suite 300, Charlotte, NC 28209, (704) 557-9600. Spaugh Dameron Tenny is not a subsidiary or affiliate of MML Investors Services, LLC or its affiliated companies. CRN202409-808372