You have likely observed individuals entering a store to purchase milk and subsequently departing with a brand-new television. You may have even held on to a stock whose value was falling because you would rather not admit that you had made a mistake. These scenarios would not be possible if traditional economic theory were true. We are expected to be “rational” actors, constantly looking for the best outcome possible for our wealth.
Reality is messy. We are emotional, human, and often irrational. This is behavioral finance. We can learn how to avoid making money mistakes by studying the intersection between psychology and economics. Understanding your hidden psychological triggers is the first step to financial freedom.
Introduction to Behavioral Finance
Behavioral finance questions the assumption that participants in markets are rational. The traditional finance models assume that people make rational decisions based on all the information they have. Behavioral finance asserts that psychological influences, biases, and prejudices influence the financial behavior of investors and practitioners. It aims to explain why people can make irrational decisions about money and why markets are inefficient. This field acknowledges that humans are not machines; they are influenced by their environment, past experiences, and the tendency of their brain to take shortcuts.
Understanding Cognitive Biases
Our brains were designed to be efficient and not accurate. We process the vast amount of information we encounter every day using cognitive shortcuts, also known as heuristics. These shortcuts can be advantageous, but they also lead to cognitive biases, which distort judgment. Confirmation bias, for example, leads us to search for information that confirms our beliefs and ignore contradictory evidence. Anchoring bias can cause us to focus on the first price that we see when shopping. We perceive a $100 shirt marked down to $50 as a decent deal, even though the shirt only has a $30 value.
How Emotions Affect Financial Decisions
When money is at stake, logic often falls behind emotion. Fear and greed can have disastrous financial consequences. Fear can drive an investor to sell their assets at the bottom, locking in the losses. Greed can make them chase speculative booms at the top. Retail therapy is a hugely emotional experience for consumers. Sadness or stress can trigger impulsive buying, providing a temporary dopamine rush. It is important to recognize your emotional state prior to making a purchase to maintain a healthy budget.
Social Influence
Social pressure plays a major role in our purchasing habits. We may like to believe that our decisions are entirely ours, but they are not. Consumers are influenced by herd mentality, which drives them to purchase products simply because others are doing so. FOMO is a major factor, especially in an age where social media allows us to see the highlights of other people’s lives. The pressure to “keep pace with the Joneses,” when we see our friends driving luxurious cars or vacationing in exotic places, can lead us to overspend and accumulate debt.
Loss Aversion & the Endowment Effect
Losing money can be a painful experience. The pain is much greater than the joy of earning the same amount. Loss aversion is the concept that explains why some people prefer to keep their money in a low-yielding savings account rather than invest in the stock market, where there are risks of losing. We value things more because we already own them, a phenomenon known as the endowment effect. It is difficult to sell or declutter assets because we are often unwilling to accept a lower price for giving something up.
Mental Accounting Explained
Mental accounting is the tendency to treat cash differently depending on its source or how we plan to use it. You might spend your tax refund or holiday bonus on luxury items because you see it as “free” money. A dollar is still a dollar, regardless of where it comes from. This mental compartmentalization can lead to irrational behavior such as carrying a high-interest debt on a credit card while keeping the money in a low-interest savings account.
Nudging Techniques in Marketing
Marketers know how to use behavioral finance to influence your decisions. This is done by “nudging.” The use of default settings is a common example. The “auto-renewal” box is often pre-checked when you sign up for a subscription. Most people leave this box checked because they are biased towards the status quo. Companies also employ scarcity tactics, such as countdown timers and “only 2 left” warnings, to generate urgency.
Practical Applications for Consumers
It is beneficial to know that awareness can counteract irrationality. You can create systems that counteract these biases once you have a more profound understanding of them. By implementing a “cooling off period” on large purchases, your rational brain can catch up to your emotions. Automating your savings will remove the temptation to spend your money in your account. You can avoid spending more money by deliberately slowing down the decision-making process.
Mastering Your Financial Mindset
It doesn’t guarantee that you won’t make another mistake. You will be better equipped to avoid the traps. You can become a more informed consumer by recognizing the impact of emotions, social influence, and cognitive biases. Next time you feel a desire to spend or a fear of missing something, ask yourself, “Is this my choice, or am I biased?”
FAQs
1. What is the difference between behavioral and traditional finance?
The traditional finance model assumes that people are rational and that markets are efficient. Behavioral finance holds that people can be irrational because of psychological biases, and markets may not be efficient.
2. Can behavioral finance help you save money?
Yes. You can develop better habits by understanding concepts such as mental accounting and impulse-spending triggers. For instance, you can automate saving to eliminate emotional decisions.
3. What are the most common financial biases?
It is common to hear people listen only to advice on finances that confirms what they want to do. Loss aversion also is very common.
4. What is behavioral finance and how does it affect marketing?
The use of scarcity and anchoring tactics (showing the original price in comparison to the sale price) can trigger psychological reactions that lead to buying.
5. Can cognitive biases be eliminated?
Biases are not hardwired in the brain. Being aware of biases can help you make better decisions.
