The Basics of Behavioral Finance – And How it Affects Investing

Money is everywhere. We’re exposed to money concepts so often in our day-to-day lives that it’s absolutely essential to understand how we deal with money in our natural environment. In other words, we need to define our own financial psychology. That means clarifying our emotions and relationships with money; and understanding what triggers us to make decisions that take us closer to or farther away from our financial goals.

We engage in financial behavior every day, whenever we take action related to money – everything from spending to saving, using credit cards, budgeting, planning, and yes, investing. Evaluating our values and attitudes toward money and how they shape our financial behaviors has multiple benefits, one of which is helping us become smarter investors.

Behavioral Finance is a relatively new field that draws from both economics and psychology. Traditional theories of finance assumed that human beings are always rational and financial markets are always efficient. Behavioral Finance rejects that assumption, asserting instead that people often make money decisions based on emotion and have cognitive biases that influence those decisions.

Our personal relationships with money start developing in childhood. Our background, environment, and watching how our parents handle money teach us lessons that affect our decisions throughout life. Lacking personal finance knowledge can lead to behaviors based on emotion, rather than rational thought. Over time we develop cognitive biases that enter into our decision-making processes without us even being aware. These cognitive biases become particularly evident when we start investing.

Following are three common cognitive biases and how they can influence investment decisions.

1) Anchoring Bias. Anchoring bias is when you tie a money decision to an arbitrary benchmark, or “anchor,” which is often the first number you hear. For example, say you’re shopping for a washing machine. Doing research online, you learn that the average price for the machine you want is $800. You go out shopping and the first store you hit has the washing machine for $750. You immediately buy it, thinking you got a great deal at $50 off. But later you go by another store that’s selling the same exact machine for $675. You could have saved yourself an additional $75, but your thought process was clouded because it was tied to the original anchor of $800.

In an investment context, anchoring bias can cause an investor to make a poor decision – like buying an overvalued stock or selling an undervalued one – based on the arbitrary anchor the person has in mind. It’s important to identify the factors behind the anchor and gather solid, quantifiable data that can help counter the bias.

2) Loss Aversion Bias. Loss aversion bias refers to a perception that a loss is more severe than an equivalent gain. That is, a person experiences the pain of losing $100 as emotionally far greater than the joy of finding a $100 bill on the street.

Loss aversion bias can be crippling for an investor. The fear of loss can be so overwhelming that people hold onto losing investments long after they should have been sold, or offload winning stocks too soon. Investors might assign far more weight to bad news than good, causing them to miss out on a bull market or panic when the market sells off. Help combat loss aversion bias by periodically rebalancing your portfolio, applying a strict formula to investment decisions, or using a buy-and-hold strategy that ignores short-term fluctuations.

3) Self-attribution Bias: Self-attribution bias comes into play when individuals attribute positive outcomes to their own behavior, but blame negative outcomes on factors outside their control. Self-attribution can lead to overconfidence, especially among novice investors who achieve quick successes early on. In turn, they could take on inappropriate financial risk, trade too aggressively, or invest more than they can afford to lose.

Self-analysis to honestly evaluate strengths and weaknesses can help counter self-attribution bias. Tracking and recording all your investment decisions and the rationale behind each can help identify any existing bias. It’s also important to seek out information from a variety of data sources, including views that contradict your own; and set realistic goals to help you stay grounded.

These are not all the cognitive biases that influence people’s investment decisions. When preparing to invest, one of the key first steps is to take stock of your emotional reactions to losing (or gaining) money. Make an honest evaluation of your risk tolerance. Set aside an emergency fund that allows you to free up risk capital – money you can afford to lose without being put in a financially insecure position. Do your homework and understand all the risks involved, including tax implications, revenue and profit margin trends. And conduct self-analysis to understand your emotional relationship with money. Have an exit strategy in place that takes all these factors into account.

Understanding Behavioral Finance can work to your advantage. Every investor, no matter how seasoned, can benefit from taking a hard look at his or her own financial behaviors and setting up systems to counter cognitive bias.