What is Behavioral Finance and How Does It Affect Our Financial Decisions?

Behavioral finance is the study of how psychological influences impact market outcomes. It can help us understand various outcomes across multiple industries and sectors. One key aspect of behavioral finance is the influence of psychological biases, which refers to the tendency to take action or make decisions in a subconscious, irrational way.  

How does behavioral finance differ from traditional financial theory?

Traditional finance assumes that investors are rational and process all information in an unbiased manner. Behavioral finance equates in real-world experience where investors do have biases, tend to be naturally irrational, and are moved by emotions within investments. Can you think back to a time when you may have reacted emotionally in a financial situation?

How does behavioral finance compare to socionomics?

Behavioral finance also studies an investor’s sociology perspective, not just a psychological point of view. Socionomics assumes that social forces drive observable economic, political, and financial trends, such as collective social mood, pop culture, financial markets, politics, culture, and norms. 

Although popular amongst investors and similar to behavioral finance, socionomic theory suggests that policies and leadership are virtually powerless in shifting social moods and that their actions in the aggregate convey social mood versus regulating it.

Examples of behavioral finance.

One example is using credit cards or loyalty schemes. When people use credit cards, points from loyalty schemes, or other cashless payments, they tend to pay more versus paying cash. They tend to remember more accurately the purchase amounts when paid in cash versus credit. 

Other examples include insurance claims, tax refunds, birthday money, and bonuses. Because these are seen as unexpected funds and not factored into their serious financial plan, people are more likely to impulsively spend this money. 

People are also inclined to associate a higher monetary value with personal attachment items. When selling them, they often cannot comprehend why so little money is offered.

These examples display mental accounting, one type of behavioral finance bias where people have the tendency to categorize money by putting different values based on mental accounts or subject criteria.

By understanding your financial behavior you can apply financial discipline, free from biases and errors. Any kind of bias distorts thinking, influences beliefs, and sways the decisions and judgments that you make daily. Sometimes these tendencies are obvious and easy to recognize in yourself and others.

Behavioral finance biases are commonly known as unconscious beliefs that influence your decisions related to money. There are four more behavioral biases that tie to bad decisions made by investors.

1. Overconfidence bias refers to seeing ourselves as better than we are, which is very common among investors. This can lead to mismanagement of risk. Overconfidence in investing can lead you to think you can accurately time the market (which is unpredictable).
2. Herd behavior occurs when investors follow the crowd versus making their own data-supported financial decisions. If all your investor connections are investing in penny stocks, for example, you may opt in even if it’s too risky.
3. Loss aversion is a bias of over-seeking gains and avoiding losses. In making decisions, studies show that people tend to be more sensitive to losses than comparable gains. This is technically why people tend to save versus invest.

Anchoring bias refers to valuing a piece of information too highly to make subsequent judgments, which can influence decisions regarding securities, like when to buy or sell investments. This can pose a problem because many investment decisions require multiple complex judgments.

Behavioral finance helps in understanding our behavior better as investors and improves our financial capability. In theory, investment decisions can be made with a more open mind based on reason and multiple perspectives.

Behavioral Finance in The Markets

The stock market is a major financial arena where psychological behaviors are usually assumed to influence market returns and outcomes. Behavioral finance helps us understand this correlation better. If we are to assume that a large number of inexperienced inventors will react irrationally in response to a market crash, there is a good chance of predicting (somewhat) what the market will do (generally) based on history.

For example, if you are aware of your anchoring bias tendencies, you may avoid holding on to a stock longer than you should because you realize that you were once focused on or “anchoring” on the higher price than you bought it at. You now know to not let the buying price bias your judgment about the stock’s true value.

Efficient Market Hypothesis (EMH)

This theory assumes that share prices reflect all information and that investors benefit from investing in a low-cost, passive portfolio. EMH hypothesizes that stocks trade on exchanges at their fair market value. Non-believers of EMH generally think stocks can deviate from their fair market values and that you can beat the market.

Investor Profiles

The three most common investor profiles are aggressive, moderate, and conservative. Each profile is defined by essential factors used in the evaluation of an investment which are profitability, security, and liquidity. Your defined investor profile will determine your risk tolerance.

Since many people fear losing money rather than are hopeful to grow wealth from diverse investments, people planning for retirement often miss out on financial opportunities. Loss-averse investors working with a financial advisor would have to come to terms with this tendency. In this case, their skewed portfolio would need to be altered, to include a healthy amount of risk.

People cling to their money for many reasons, which can stem from extreme loss aversion. Some of these thoughts include:

1. This is all the money I have. 
2. Loved ones are telling me to play it safe.
3. I don’t understand investing.
4. I’ve had a bad investment experience.
5. I don’t understand loss and volatility.
6. I don’t know who to trust.

This non-action safeguard of funds is not a strategy—it’s a financial life sentence. Keep in mind that depletion of principal reduces your future income, which you have to live off of for the rest of your life. So in essence, if you’re only living on saved up cash, you will be guaranteed to lose money each month. 

Ask a financial advisory firm that specializes in behavioral finance for help in getting past this roadblock if it hits close to home. And remember, there is no shame in practicing what you were taught. Psychologically, we stick to what we know and what feels safe, right?

The fear of poverty may be more familiar than the hope for riches. Generational perspectives are being overcome by those who experienced the Great Depression, which FDR pulled America from with the New Deal. He also created Social Security in 1935 as a federal safety net for the unemployed, disadvantaged Americans, and elderly. 

Read: Does Social Security Count As Retirement Income?

The original Social Security Act was to pay retirees over 65 financial benefits based on lifetime payroll tax contributions. Keep in mind that this was designed as an insurance program rather than a pension plan or savings program; however, some rely on SS more than they should. Others simply don’t understand the pitfalls of claiming their benefits too early, versus waiting as long as possible to max out on benefits.

Is it time to figure out your monthly retirement income?

The major difference between fear-based versus financially aware SS claimers: “Early claimers feared benefit cuts in the future, needed money or were in poor health. Late claimers had IRAs or 401(k)s and were better educated.”

Learn about your retirement income gap and how to avoid it.

We are products of our environment until we learn better. As mentioned, we stick to what we know, which is what makes learning about behavioral finance so important to financial success. 

If you learn primarily from your parents, you naturally pick up their tendencies, habits, and behaviors. If recognized and tended to, financial mistakes can be avoided which can save multiple generations from financial distress. Behavioral finance biases may lead to poor investment decisions, which can also be nipped in the bud.

Mamma and pappa bears, be mindful of how your emotions might influence your spending. Remember, those little minds absorb all you say and do like sponges, so teach your children well. 

There are many practices for parents to set their children up for financial success. For example, you can teach them when they’re young about:

• The importance of saving versus spending  
• Create opportunities to earn money
• Help kids make smart spending decisions
• Teach children about giving
• Show kids how their money can grow
• Help them build credit 
• Set up trust fund(s) 

Most importantly, you can model good financial behavior. By understanding how you behave in correlation to financial markets and having basic financial literacy, you can become a more seasoned investor and ultimately grow your wealth, helping younger generations do the same.

The biggest financial enemy you may need to make peace with could be yourself. Overcoming strong influences of self, society, and your immediate environment may be hindering your ability to achieve financial success. 

Making change begins with awareness. By understanding the behavioral finance theories and behavioral financial biases, you can begin to unravel the wonderment of your financial setbacks. Perhaps you will have a better understanding of your loved ones and enable yourself to lead your children with more sound investment advice.

Explore 6 effective retirement strategies 

Hiring the right financial advisor can help you make smart money moves with tactical investments to protect what you’ve worked so hard to achieve.