- Behavioral finance biases can influence our judgment of how we spend our money and invest.
- Common pitfalls include mental accounting errors, loss aversion, and herd behavior.
- Understanding these biases can help you overcome them and make better financial decisions.
Imagine finding $100 on the street. Would you spend it on an expensive meal? Where would you invest it?
The answer lies in behavioral finance, which examines how our brain affects how we manage and invest money.
What is behavioral bias in finance?
Behavioral finance is a field of study that focuses on the psychological factors that influence investors’ decisions in financial markets based on how they interpret and act on specific information.
Behavioral finance researchers have discovered that there are many mental shortcuts we use when making complex decisions. These heuristics can bias our judgments and lead to missteps with our money. Behavioral biases are unconscious beliefs that influence our decisions. And they can affect your money too.
Here are five common cognitive biases that can affect your relationship with money — and what you can do to overcome them.
1. Mental Accounting
What it is: Mental accounting refers to the concept that people treat money differently depending on where it comes from and what we think it should be used for.
The idea is that we separate our money into “mental accounts” for different uses, which influences our spending decisions. We keep money cautiously when mentally categorizing it for a home, but spend it generously when it’s “fun money.”
This is why most people are more likely to spend windfall earnings on luxury items, but would save the same money had they earned it. The money earned was mentally assigned to an account, but the $100 you find on the street was not.
Why is it a problem : Mental accounting can sometimes hurt your bottom line. For example, someone might choose to keep money in their college fund instead of paying off their credit card debt. The money is already “booked in”, which means they would be forced to pay high interest on their credit card bills to have a balance each month.
If they had chosen to pay off their credit cards instead, they could use the money that would otherwise have been spent on interest to replenish their child’s college fund – or even use it to invest and create a long-term wealth.
How to overcome it: Create a budget to guide your financial decisions and better determine when to save or spend money. And create a plan for how to spend windfall earnings, such as an inheritance or work bonus, in advance.
2. Loss aversion
What it is: Loss aversion is a tendency to avoid losses rather than seek gains.
Robert R. Johnson, professor of finance at Creighton University’s Heider College of Business, argues that loss aversion can cost us money. “The biggest financial mistake people make is taking too little risk, not too much risk,” he says. Loss aversion helps explain why: losses hurt more than gains are savored.
Why is it a problem : Loss aversion causes us to avoid small risks even though they are probably worth it. This is why people save rather than invest, even though inflation erodes the value of their savings — and many investments, when held long enough, pay off.
“The surest way to build wealth over long-term horizons is to invest in a diversified portfolio of common stocks,” Johnson says. “A person with a long-term horizon shouldn’t be exposed to low-risk, low-return instruments like money market funds, but many investors do this because they fear stock market volatility.”
How to overcome it: Don’t rely on emotion. Create an investment strategy and stick to it. Make a mental effort to adopt some risk by considering assets that generally perform well, such as an index fund that tracks the S&P 500.
3. Overconfidence bias
What it is: Overconfidence bias is the tendency to see ourselves as better than we are. This is common in investing. A 2020 study published in the International Journal of Management found that overconfident individual investors generally fail to manage and control risk properly.
Why is it a problem : The problem with overconfidence bias is that it can cause an investor to overestimate their abilities and knowledge, which can lead to rash or bad decisions. For example, overconfidence in investment skills can lead someone to believe that they can accurately time the market (even though markets are notoriously unpredictable).
How to overcome it: If you’re a newbie investor, consult a professional and get a thorough review of your investment strategy to solicit other prospects. And consider sticking to passive investing rather than trying to time the markets. After all, active traders tend to fare worse than buy-and-hold traders.
4. Anchor bias
What it is: Anchoring is a phenomenon where someone values initial information too much to make subsequent judgments. In investing, this can influence decision-making about a security, such as when to sell or buy an investment.
Why is it a problem : Since many investment decisions require multiple complex judgments, they are vulnerable to anchoring bias.
For example, a person may hold a stock longer than they should because they have “anchored” themselves to the higher price at which they bought it. The purchase price biases their judgments about the true value of the stock.
How to overcome it: Take the time to research and make a decision. A full valuation of an asset’s price helps reduce anchoring bias. Finally, be open to new information, even if it doesn’t necessarily match what you initially learned.
5. Herd behavior bias
What it is: Herd behavior occurs when investors follow others rather than making their own decisions based on financial data. For example, if all your friends invest in penny stocks, you could start too, even if it’s risky.
People follow the herd because they feel safer. There is also the “fear of missing out”: if your colleagues are making money by investing in a particular stock, it is uncomfortable to stay away.
Why is it a problem : Herd behavior can backfire. This can create massive bubbles like the Dutch tulip market bubble, the Dot-Com bubble, and even the housing bubble of the mid-2000s…and the bubbles burst.
How to overcome it: Take a step back and take a hard look at investments: dive into the fundamentals of a company and see if it actually looks like a solid investment. And be skeptical of hot stocks promoted on internet forums.
The bottom line
Economists like to think that we make financial decisions by maximizing returns and optimizing our bottom line. But the reality is that our decisions are influenced by a number of factors, including emotions and cognitive biases.
This can lead to financial errors. Being aware of them helps you avoid them. And having a financial plan to guide you is an important next step in making smart investment decisions.