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    Think Your Financial Decisions Are Rational? Perhaps Not

    By Brandon Miller, CFP–

    You probably think that your financial decisions—to save or spend, buy or sell—are based on taking in all of the information at hand and selecting the right option for you. Psychologists know better.

    The truth is, every decision that you make is influenced by subconscious biases. Financial decisions are no different. You can do all of the research you want to on investing, but if you don’t account for your blind spots, your decisions might have unintended consequences.

    Preconceptions can sometimes work in your favor, but just as often, they can cause you to lose money, opportunities or sleep. And personal biases across the greater population can lead to market swings, bubbles, panics and other irrational behaviors.

    Researchers have started studying how human foibles impact portfolios, markets and whole economies in a field known as behavioral finance.

    Behavioral Finance and How It Helps You        

    Behavioral finance aims to explain why people make the money choices that they do. It combines economics with psychology, particularly cognitive reasoning, to identify the mental shortcuts that people use to make decisions about how to spend, save and invest their money.

    What does it offer you? Being aware of the biases that can creep into your decision-making allows you to adjust your behavior and make more rational—and hopefully, more profitable—choices.

    Some of the most common biases include:

    Herd Mentality

    Following the crowd is common, whether that’s buying a hot stock or selling in a panic when the market drops. If you’re tempted to do what everyone else is doing, take the time to think if it’s really right for you.

    Overconfidence

    Most people think that their successes are something they caused and that their setbacks are due to external forces. So, you’re a genius when your stock rises, but a hapless victim if it tanks. This can tempt you to take on more risk than necessary or keep a losing investment longer than you should.

    Mental Accounting

    People have a tendency to allocate money for various purposes, putting it into separate “accounts” and treating it differently depending on which account it’s in. The issue with this bias is that it can keep you from putting your money to its best use. For example, you may have a rule that once you add money to your savings, you’re not allowed to touch it. But it may make more sense to pay down high-rate debt that costs more than your savings earn.

    Value Attribution

    All of us make buy or sell decisions based on values that we attribute to the item. These may or may not be based in reality. For example, you might be willing to pay $200 for shoes from Nordstrom because you believe that they are high quality, but you would balk at that price if they were at Payless. An example of how this can hurt you is a losing investment that you won’t sell until it reaches the price you paid for it, even though cutting your losses might be smarter.

    Behavioral finance has enormous potential to add to our understanding of what motivates people and moves markets, and it can lead to a wide range of improvements in the industry.

    While it may be a relatively new field of study for researchers, good financial advisors have always understood that financial planning is as much art as science. Humans aren’t always rational, so you can’t base decisions solely on what makes financial sense. It’s our job to use what I call a reality overlay to make sure the plan fits the person.

    For example, a client might believe that paying off their house before retirement would be best, so they add $100 extra to their monthly mortgage payment. With a low interest rate and tax advantages, the numbers say that it would be better to invest that extra money each month. But if I know my client would likely fritter away the extra cash rather than invest it, it makes more sense to keep adding the $100 to the mortgage. 

    Bringing your hidden biases to the forefront can add another arrow to your quiver when you’re aiming for financial independence. Or you could just rely on your friendly neighborhood financial advisor to save you from yourself.

    Brandon Miller, CFP® is a financial consultant at Brio Financial Group in San Francisco, specializing in helping LGBT individuals and families plan and achieve their financial goals.