You might not think all that often about behavioral finance, but you should. That’s because the more you understand about your motivations around money and investing, the better off your financial decision-making outcomes are likely to be.
While behavioral finance only became a widely accepted field of study with the work of psychologists Daniel Kahneman and Amos Tversky (among others) in the 1970s, since then, its applications, both academically and economically, have become mainstream. (At least four people have won Nobel Prizes for their work in behavioral finance in just the last 20 years.)
Briefly, behavioral finance posits that when it comes to making decisions about money and investing, most people aren’t typically rational or calculating, but are instead overly influenced by emotion and bias.
So, before I delve into how these biases impact, and sometimes even ruin, financial decision making, I get to repeat something which I believe is at the foundation of how a good advisor serves clients.
When we work together, it isn’t merely the investment selection, estate and tax recommendations, or the holistic financial plans that we build together that are valuable. From my perspective, the most important thing I do is to keep clients from making emotional mistakes about money and investing from which they won’t recover.
It is difficult to quantify the value of something that has never happened. But as an example, if you have worked with us for long enough, you’ve been through a bear market. When faced with a down market, you may have wondered, and you may have even asked your advisor, if you should pull out of the market and move to cash.
Coaching clients to stick with their plans is a key part of what we advisors do.
And with that in mind, in my 30-plus years of advising, in part, due to the high value I place upon it, I’ve been quite successful at keeping my clients focused on the long term. But over all those years, there have been a handful of times when I just could not convince someone to stick with their plan. Sometimes, unfortunately, fear gets the best of people. And of those few people who could not be convinced to stay the course, and who pulled out of the market when their investments hit a rough patch, many never financially recovered because they not only missed out on the market rebound (which sometimes can occur in a single day), they permanently locked in their losses.
So, from an advisor’s perspective, behavioral finance is helping to keep clients focused on the long view instead of reacting to what is happening on any given day, month, or cycle.
What follows are 5 aspects of behavioral finance and how they can impact decision making.
1. Mental Accounting
Mental accounting refers to the habit of assigning subjective values to money in a way that harms us economically. Obviously, inflation aside, a dollar is a dollar is a dollar. It has consistent, objective (and not subjective) worth. Mental accounting can become problematic when we apply unique rules to our money depending upon how we feel when we spend it.
For example, if you consistently save well, and hate spending money on things such as vacations, but each month you spend your budget on racks of new clothes because of how buying them makes you feel, that’s a form of mental accounting.
While there is certainly nothing wrong with buying new clothes that you can afford, assigning different values to the exact same amounts of money makes us vulnerable to scams and slick marketing campaigns.
2. Herd Behavior
Herd behavior is the instinct to do what everyone else is doing. This phenomenon is a big reason for bear markets as individual investors see a trend and then react based on what they perceive everyone else to be doing.
Among other perils, giving into the instinct to follow the herd is what created the Tech, housing, and dot.com bubbles.
3. Anchoring
Most of us have the tendency to believe that the value of an item correlates to how much it costs. For instance, I have a friend who I have noticed innocently believes that the more expensive a bottle of wine is, the better the quality.
As it pertains to behavioral finance, anchoring can trick us into ignoring obvious clues about the true value of something. This can cause someone to overpay or ignore an otherwise excellent value due to our perception that price is the best indicator of a stock’s (or of any item's, for that matter) actual worth.
4. Self-Attribution
While confidence is usually a great trait to possess, have you ever thought you knew everything there is to know about a particular topic, only to find out later that you were wrong? It happens to us all, and when it does, it can be jarring to learn we do not know as much about something as we may have long believed.
Self-attribution is when we make decisions based on the belief that we know more about something than we do, or when we are over-confident about something in relation to our actual level of skill.
5. Emotional Gap
An emotional gap occurs when our feelings motivate our choices about money. The most common emotions associated with money include fear, anxiety, greed, and enthusiasm.
When emotion dictates our financial decisions, it can negatively impact our judgment because it pulls us further from our rational selves.
While understanding behavioral finance is interesting, and while it can help people to make better decisions about money, it’s not perfect. For one thing, while it can give us insights into our patterns and motivations, and while it’s an integral aspect of advising, it does not actually provide individual investors with alternatives.
In the end, everyone’s financial situation is unique. So, when I work with a client, along with learning about their current financial situation, and of course, their goals and dreams for the future, understanding their history, and the types of decisions they’ve made about money, helps me to be a more effective advisor.
