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What is Behavioral Finance?

March 22, 2021 · 5 minute read

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What is Behavioral Finance?

People sometimes make financial decisions based on emotion rather than rational thinking: “I deserve that new car!” or “My gut tells me this would be a great investment.”

Other times, they make decisions based on faulty information: “I know exactly why buying that last stock worked out so well for me.”

In fact, these two types of decision making—often referred to as “emotional biases” and “cognitive biases,” respectively—take place often. How has information about such biases been discovered and analyzed? Through a relatively new discipline known as behavioral finance or behavioral investing.

Behavioral Finance 101

Behavioral finance theory combines the field of finance with that of psychology. It focuses on how people handle money and on what biases they may have that can affect their financial management.

In other words, this discipline looks at how investors behave, including whether they have self control. It looks at investors’ ability to rationally make decisions without their personal biases having a negative effect on their finance-related behaviors.

Traditionally, economists tended to believe that people and groups acted logically when making financial decisions, taking actions that would be in their best interests.

Over the past few decades though, that belief has been increasingly challenged—with behavioral finance theory suggesting that there limits to the amount of rationale a person may have, which means that they’ll make errors, in part because of behavioral finance biases.

Financial Psychology: Money and Emotion

As human beings with feelings, emotions naturally factor into decisions we make, which means that finance-related decisions are seldom (possibly never!) 100% logical.

The goal, though, isn’t to try to squeeze out every single drop of emotion from decisions that are being made. Instead, the idea is to prevent emotional factors from having a negative impact on financial decisions, including when investing.

Recommended: Emotions and Finances

Ways to help prevent that from happening can include taking time to make financial decisions; creating goals and aligning actions with them; reasoning out how much money can comfortably be lost when investing; and avoiding making a decision just because other people seem to be making it too.

Here’s another key part of this type of financial psychology. It’s important to become aware of behavioral finance biases to help prevent them from playing a negative role in decision making.

Behavioral Biases

According to Psychology Today , biases can, overall, be helpful or harmful. Here’s an example of a positive bias: deciding to eat fresh fruits and vegetables instead of candy because of a belief that the former is a healthier choice. Other biases, though, can cause a person to make rash decisions that aren’t helpful.

Biases tend to be cognitive or emotional in nature, and behavioral finance definitions of biases can be as follows:

•  Cognitive biases: These include situations when financial rules of thumb that an investor believes in may not be accurate.
•  Emotional biases: These include when an investor makes a decision based upon how they feel at the time or because of deep-rooted emotional issues: “My father always invested that way and so I will too.”

Biases in Investing

Here is a list of behavioral finance biases, emotional or cognitive. It’s not a complete list but offers a range:

•  Overconfidence bias is when a person believes that they know more about finances than they really do. When someone has this bias, they may not take the time to learn information that can help them handle their finances more effectively in the future, and so they have the potential to keep making the same kinds of mistakes.

For more insights into your own degree of financial literacy, here is a helpful quiz. Plus, here’s an investment quiz.

•  Confirmation bias can play a role. People often pay more attention to opinions of others who agree with them, rather than seek out information that may conflict with their beliefs. They also then don’t rationally make a decision based on multiple viewpoints.

Closely related to confirmation bias is something called the bandwagon effect. With this phenomenon, investors may follow the path of the crowd where, in fact, this can sometimes be counterproductive.

•  Hindsight bias is another form of a cognitive bias. In this scenario, an investor may buy a stock that does well. They attribute that to their personal investment skills when, in reality, the stock may have gone up for external reasons.

•  Anchoring bias is when an investor relies upon the first bits of information uncovered. So if a stock is at a certain price when the investor is first exploring it—and, on a second look, the price has moved—then the investor would evaluate the second price based on the first.

If it’s gone up, then the investor may think it’s too high. If it has gone down, the investor may wonder why its value has lessened, rather than effectively analyzing the investment opportunity as it is presented today.

•  Loss aversion bias is how investors tend to avoid losses more than seek gains. This can lead to reluctance to sell a losing position and a tendency to become too risk-averse after suffering a loss. For example, when it comes to money management, it can be tempting to keep your money in cash. But then investors are ignoring the risk of inflation devaluing that money. Safe investing can help mitigate this risk.

What About Gender Differences?

So what does financial psychology have to say about gender differences when investing? Quite a bit. Many different studies share illuminating information on the subject and here are highlights:

•  Women keep 71% of their assets in cash while men only hold 60%, with males being more likely to invest than females. Plus, men are more likely to want to be investors.
•  Women tend to be less confident in their ability to invest, including in younger generations like Millennials. The more that a woman’s portfolio grows, though, so does her confidence.
•  Overall, women are better investors, performing better than men by 0.4%. Over time, this can make a big difference in portfolio size, especially since women typically save slightly more for retirement than men.
•  Overall, men are more comfortable with taking risks—and this also carries through to the Millennial generation.
•  Women are more patient when it comes to investing, trading less often.
•  Women are more willing to ask for investment advice. In fact, twice as many women are open to doing this than men are.

Recommended: A Beginner’s Guide to Investing in Your 20s

None of these gender differences, of course, are written in stone. In each of these categories, men and women alike can learn how to do what’s best for their investment portfolios. And, in general, the more you learn about your behavioral finance biases, the more you can learn about personal behaviors that may be preventing you from maximizing your financial opportunities.

As you identify personal biases and work on managing them, the more successful you could be with reaching your financial goals. One easy option is to automate your finances, including with savings and investing.

The Takeaway

Behavioral finance is a branch of psychology and economics that looks at how decision making in money management and investing can be impacted by cognitive tendencies. It’s a relatively new field that’s challenged the traditional notion that humans tend to make rational decisions when it comes to matters related to money.

In fact, short-cuts in our brain and different ways we’ve been primed by evolution (such as “flight or fight”) can lead us astray when it comes to financial decisions. Understanding behavioral finance can be important in helping individuals and investors avoid making the same mistakes over and over again when managing their finances.

This is particularly important as retirement and savings practices have shifted away from defined benefit options like pension plans and into more self-directed options like 401ks or retail brokerage accounts.

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