Behavioral Finance: The Secret Ingredient to Your Financial Success
Just one visit to the grocery store—where the aisles are suddenly stocked with candy canes and the speakers serenade shoppers with carols—proves it’s true: the holiday season is already upon us!
While Americans daydream about (and shop for) their holiday plans during this time, their financial plan is often an afterthought. But if there’s one unwanted gift the holiday season brings for your budget, it’s an uptick in emotional buying decisions.
In the tumultuous world of finance, where fortunes are made and lost in the blink of an eye, mastering the art of decision-making is paramount. Behavioral biases, deeply ingrained in human psychology, often lead us astray in the labyrinth of financial choices—and we may not even notice. Fortunately, an understanding of the tenets of behavioral finance can help you learn to notice those destructive patterns—and nip them in the bud.
Let’s take a deeper look into some common biases that can affect our financial behaviors—and tactics for mitigating them.
Understanding Behavioral Finance
While traditional finance assumes that people always act rationally and make decisions based on objective facts and figures, behavioral finance allows that emotions, for better or worse, play a key part in financial decision-making.
Anxiety, anger, fear, excitement, and more can lead us away from rationality—and, in some cases, into the influence of cognitive biases. Here are a few of the most common.
Mental Accounting: Mental accounting is the tendency to create mental labels for money based on its origin or deemed purpose. For example, many of us are happy to blow our tax refund on frivolous splurges, but exercise more caution when it comes to spending our paychecks. Although both types of funds can be considered income and aid overall cash flow, we treat them totally differently just because of how we get them.
Herd Behavior: The herd behavior theory states that people—including investors—mimic the actions of their peers and the majority, rather than making independent decisions based on their own analysis and information. This behavior was prominent during the COVID-19 pandemic with trendy investments like GameStop and cryptocurrency.
Anchoring: Anchoring occurs when people fixate on an initial piece of information (the anchor) and make decisions based on that reference point. This is how many discounts and sales work: when we see how much lower the current price is than the original, it feels like a bargain, even if it’s still objectively spendy for our budget. (Another example of anchoring: spending consistently according to a budget, without adjusting it in response to income or market changes.)
Confirmation Bias: Confirmation bias involves seeking out and giving more weight to information that confirms what we already believe while dismissing contradictory evidence. This bias can cause investors to selectively filter information and potentially miss relevant information that runs counter to their viewpoints—which doesn’t work out well when that information could have led them to better decisions in the long run.
Self-attribution: Self-attribution refers to a tendency to make choices based on overconfidence in our own knowledge or skill, attributing positive outcomes to our expertise but negative outcomes to factors outside of our control. For example, we might see a chancy investment that happens to have great returns as clear proof of our market savvy—while one that tanks as simple bad luck.
Representativeness Bias: Representativeness bias prompts us to make judgments based on stereotypes or prior experiences rather than considering the statistical probability of an event. For investors, that can translate into misjudging the potential of an investment because it resembles a past winner or loser.
Tips to Mitigate Common Behavioral Pitfalls
Behavioral biases can affect anyone, regardless of discipline, knowledge, or intent. Lapses of judgment and taking emotion-based actions are part of being human. Still, there are some easy strategies you can take to get ahead of those biases and oversights—and improve your finances in the meantime.
Diversification: It’s been said a time or two—but it’s true, especially when it comes to mitigating the impact of the representativeness bias. Diversify your portfolio across multiple asset classes to help keep your risk levels as low as possible.
Nudging Strategies: Behavioral “nudges,” such as reminders and goal setting, can be a great way to keep your financial behaviors on track. For example, setting maximum or minimum spending thresholds within your favorite budgeting tool or simply utilizing the reminder functions within your phone can keep your financial goals top of mind.
Regular Reassessment: Clients, along with their advisors, can combat anchoring bias by making a point to regularly reassess their investment strategies in light of new information and market conditions. Doing so means less fixation on historical valuations and prices, which can also help tackle the representativeness bias.
Emotional Resilience: Financial coaching to help you develop emotional resilience in times of uncertainty, such as market crashes or economic crises, can pay dividends in the long run. A financial coach can show you how to enact important emotional soothing tactics, like cool-headedness in the face of market fluctuations (which are, of course, normal), taking a break before making rash decisions (which often lead to losses), and developing the understanding that past circumstances are just that—in the past. All of these can help foster financial clarity and sound decision-making.
While cognitive biases and heuristics can cloud our judgment, recognizing them is the first step toward combating them—and walking into healthier financial behaviors. Here at Felton and Peel, we take a holistic approach in working to understand both your personal and financial circumstances to help carve out your best financial outlook, emotions and all.