By Brandon Miller, CFP–
You probably think your financial decisions to save or spend, buy or sell are based on taking in all the information at hand and selecting the right option for you. Psychologists know better.
The truth is, every decision you make is influenced by subconscious biases. Financial decisions are no different. You can do all the research you want 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 they do. It combines economics with psychology—particularly cognitive reasoning—to identify the mental shortcuts 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 their successes are something they caused and 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 is 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 we attribute to the item, which 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.
Good financial advisors have always understood that, while it may be a relatively new field of study for researchers, 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, so 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.
The opinions expressed in this article are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security. It is only intended to provide education about the financial industry. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. Any past performance discussed during this program is no guarantee of future results. Any indices referenced for comparison are unmanaged and cannot be invested into directly. As always, please remember investing involves risk and possible loss of principal capital; please seek advice from a licensed professional.
Brio Financial Group is a registered investment adviser. Advisory services are only offered to clients or prospective clients where Brio Financial Group and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Brio Financial Group unless a client service agreement is in place.
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. For more information: https://www.briofg.com
Money Matters
Published on April 18, 2024
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