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What is Behavioral Finance?

February 19, 2019 · 6 minute read

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What is Behavioral Finance?

This may be hard to believe, but the person most likely to sabotage your financial success is, well, the person staring back at you in the mirror. You are most likely to trip your own self up.

Legendary investor Benjamin Graham said it best: “The investor’s chief problem—and even his worst enemy—is likely to be himself.” This “problem” can manifest in many ways in a person’s financial life; we can create roadblocks for ourselves when it comes to making all sorts of financial decisions.

This phenomenon of self-sabotage is what the field of behavioral finance sets out to understand.

Behavioral finance studies the psychology of financial decision-making, using the insights of behavioral and psychological research and applies them to how humans handle money.

As it turns out, we’re not very good at handling money, both as individuals and collectively. That’s because making rational, emotionless decisions with money is hard with our caveman brains and prehistoric hardwiring. We tend to make decisions based on emotions and according to our biases a lot more than we realize.

Below, we dive deeper into the question, “What is behavioral finance?” and investigate the ways in which our own human biases can affect our financial decisions and lives, and how to hopefully overcome these challenges.

Exploring Behavioral Finance?

The field of economics was built upon the notion that all players in an economic system—individuals, groups, and organizations—are acting rationally and in their own best self-interest. But, the more we’re able to study the behavior of the participants, the clearer it has become that the assumptions on which traditional economics were built may be on pretty shaky ground.

Enter into the picture: Behavioral finance (also known as behavioral investing).

Behavioral finance is the study of how human nature causes us to make irrational economic choices. It wasn’t until the last few decades that economists and behavioral psychologists began exploring behavioral finance as we know it, and it continues to be an ever-growing and evolving field.

To understand behavioral finance, it helps to have an understanding of the assumptions that frame traditional finance and economics. Some of these assumptions include: All people are rational, are not subject to substantial errors of processing, are non-emotional in their decisions, and exercise self-control.

But the more we come to understand humans in all of their imperfection, the more we question the assumptions of traditional finance. In behavioral finance, it is believed that humans have limits to their self-control and rationale, can and will make cognitive errors, and are influenced by their own biases.

Cognitive Biases in Behavioral Finance

A cognitive bias is a mistake in a cognitive process such as reasoning, evaluating, and remembering that occurs when people are interpreting information in the world around them.

Think about it: The world presents us with an incredible amount of stimulus every minute of every day, so much that we can’t possibly evaluate every detail before forming our thoughts and making decisions. Therefore, we make a lot of decisions using mostly our instincts. Because there is simply no way to consider every piece of stimulus prior to making a decision, it leaves ample room for bias to creep in.

When you learn about some of the biases that humans exhibit in making money decisions, it helps to think in terms of the evolution of the brain and our need to stay alive in nature. Here are a few cognitive biases along with examples of how they might manifest within financial behaviors and decisions:

Anchoring

When a person selects some sort of psychological benchmark that carries a disproportionately high weight in their decision-making process. Often, this benchmark is an arbitrary number.

Example: Someone says that they will start saving money once they start earning $70,000, even though this number has no particular financial meaning and the person could be saving money now.

Herd Mentality

By nature, humans are herd creatures. We want to be loved and accepted by our community, and often make decisions based on what the group has already done.

Example: Look at any mania (or panic) during stock market cycles. If everyone is excited about stocks, including family members, friends, the news media, etc., than it may make you excited about stocks too.

You may want to jump on the bandwagon. But in reality, this may just mean that the stock market has already come up, and that it may not actually be the best time to invest. The reverse can also be true during panics.

Confirmation Bias

This is the tendency of humans to pay closer attention to the information that supports what they already believe. They may even seek information out that matches their belief system.

Example: Say that investor is avoiding investing because they are afraid of a big market drop. They read an opinion piece that advises people to stay away from investing. This confirms the investor’s biases, and they decide that this is good enough evidence that they should remain out of the market.

Overconfidence

Humans tend to be overly confident in their own abilities. This fearlessness helped keep us alive for many thousands of years in the wild, but can lead us to hurt ourselves in financial matters.

Example: A person may strongly believe in their own ability pick stocks and “beat the market.” This could lead to excessive buying and selling, which racks up transaction costs within a portfolio. It is already difficult to beat the market, but even more so when overcoming high transaction costs.

Loss Aversion

Studies have shown us that humans hate losing more than they like winning. Because of this, humans may avoid scenarios where they could potentially lose money, even if it is good for them in the long run.

Example: Because a person is scared of losing any money at all, they do not save and invest any money for retirement. They avoid saving and investing even though they have many more years for the stock market to work in their favor, and it would be in their best interest to save and invest their money.

Hindsight Bias

The belief that you got something right because of knowledge you accumulated after the fact. Said another way, it is the act of getting lucky and believing that it was due to skill.

Example: An investor buys a stock and it goes up. They believe that it is because of their superior stock-picking skills, and not because there was a random external event that caused the stock to go up.

Overcoming Your Own Biases

The plain truth is, the more you learn about behavioral finance, the more adept you can be at identifying self-harmful behaviors within yourself.

The more you are able to identify and potentially quell these behaviors, the better with money you can ultimately become. If your goal is to have a bountiful life, perhaps add learning about behavioral finance to the list alongside learning tracking your money and investing.

A relatively easy thing that you can do to help overcome your own cognitive biases is to automate your finances. This could be a useful technique in both saving and investing your money. Here are some ideas:

Automating Savings

Get money out of a checking account and into a savings account where you won’t be as tempted to spend it. To do so, contact your bank about setting up a monthly transfer of cash a few days after your paycheck hits.

If you can, store your savings in a cash management account like this one from SoFi Money®. This cash management account has no account fees (subject to change), includes P2P transfers, and you can save, earn, and spend all in one place.

Using Your Automatic 401(k) Contribution

A 401k or other workplace retirement account can be a convenient way to have money taken directly from your paycheck and placed in a savings account. Generally, you elect a percentage of your salary or a dollar amount and it is done automatically.

Automating Investing

Within your 401(k) or other retirement accounts, you may be able to auto-invest in a target-date fund based on your age and risk tolerance. Contact your administrator to determine how to set this up. Systematic investing can help you avoid the trappings of believing that you can time the market or that you have any control over markets—which you don’t.

The more you can systematize your savings and investing, the less room there may be for cognitive biases to come in and muck everything up.

Our brains are these beautiful systems that were designed to keep us alive in nature for many thousands of years, but they don’t always process information and make decisions in our own best self-interest when it comes to modern things, like saving and investing money in the stock market.

Being aware that we sometimes make decisions based on fight or flight mechanisms, or based on preconceived ideas or cognitive biases, can go a long way in helping you to overcome these biases to become the best and most self-aware version of yourself. Cognitive biases are hard to “beat,” but knowing is half the battle.

Ready to get your money right? Open a SoFi Money cash management account today!


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