Have you ever found yourself struggling to stick to a budget, despite your best efforts? When an investment you picked does particularly well, do you notice how proud you are? And if it underperforms, it is clearly due to unforeseeable economic conditions, right? If an unexpected car repair pops up – do you find yourself carrying that balance on a credit card rather than drawing on your vacation savings to cover the expense? Each of these scenarios gives us a peek into how our psychology influences our financial choices, for better or worse. The good news is that you can learn to recognize common missteps and consciously choose to adjust your strategy with behavioral finance.
So, what is behavioral finance? It’s a field of study at the intersection of psychology and finance that seeks to understand the motivations behind individuals’ (sometimes irrational) financial decision-making processes. Classical economic theory proposed that, given proper information, investors make logical decisions. In contrast, behavioral finance recognizes the impact of our attitudes and values, in concert with cognitive errors and emotional biases.
Attitudes & values
As with any aspect of our lives, our financial personalities are influenced by our opinions, desires, and values. Additionally, our broader life context—a patchwork of our culture, religious upbringing, family structure, age, and life stage—informs our decision-making in the investment space as well. If you are passionate about issues like climate change, you’re more likely to prefer investing in companies that proactively work to offset their environmental impact or are involved in researching renewable energy sources. Or maybe your child has exhibited raw talent for soccer, and you want to invest in their natural athleticism by making space in your budget for their increasing registration, equipment, and travel expenses.
Cognitive errors
Let’s take a look at a couple of examples where imperfect logic comes into play. The aforementioned car repair hypothetical displays the error of Mental Accounting. This our tendency to place our savings into clearly delineated “mental accounts” earmarked for specific uses. While it pains us to think of spending our vacation savings on a boring obligation like car repair (“That was supposed to be beach money!”), putting the expense on a credit card charging upwards of 20% interest instead only puts our larger financial goals further out of reach.
The investment picking scenario highlights the error of Self-attribution Bias. When our decisions produce positive results, we strongly prefer to credit those to our intelligence or keen discernment skills. However, when the results are negative, we seek to shift the blame to others or external forces beyond our control rather than claiming the failures as our own.
Emotional biases
Next, we’ll turn our attention to the effects of our emotions. Budgeting challenges are a great example of Self-Control Bias. Until we commit to long-term goals that are sufficiently meaningful to us, making the small delayed-gratification choices that add up can feel like an unsustainable level of self-denial. It’s not that we’re never allowed to buy a nice latte, or a newer car – it’s a matter of prioritizing our long-term needs for retirement over our immediate wants at an earlier stage of life.
If you’ve ever experienced decision-paralysis, then you likely will recognize the common stumbling block known as Regret Aversion Bias. When facing a key decision, you may prefer to avoid deciding at all rather than potentially choosing a less than ideal, or even outright wrong, option. In practice, recurring regret aversion can lead to long-term underperformance of investment portfolios as the predisposition towards overly conservative choices, or simply non-action, may preclude the potential for increased growth found in more aggressive assets.
What this means for you and your portfolio
So, with your newfound awareness that your investment decisions may be less logical and more emotional than intended, what do you do? Take some time to look at your finances with fresh eyes. Are your day-to-day choices (which we’re now acknowledging are swayed by potential errors and biases) serving your long-term, value-aligned goals? If so, great! But if not, don’t despair. A world of resources exists to help, including collaborating with a financial advisor to prioritize your financial goals and develop personalized, sustainable strategies for reaching those goals in practice, rather than just in theory.
The scope of behavioral finance goes far beyond the limited items discussed here. If you’re curious about how your finances could be improved through increased awareness of your own biases, feel free to reach out to us to start the conversation.