Investing often has as much to do with psychology and human emotions as it does with the placement of money into various assets. For insights into emotional aspects of investing, we can learn a lot from the growing field of behavioral finance. Behavioral finance combines two disciplines – psychology and economics - to explain why and how people make seemingly emotional or illogical decisions with respect to spending and saving money. Traditional economics is based on the assumption that people behave rationally but, in real life, many times we do not. Below is a description of six common behavioral finance errors:
1. Mental Accounting – This is where people separate their money mentally into different “accounts.” A dollar in one location is valued as more or less important than a dollar in another. Mental accounting can be a good thing when it helps people focus on their future financial goals, like saving for a car or retirement. It can also cause problems when “the big picture” of one’s finances is ignored. An example of a mental accounting error is carrying a 17% credit card balance when money to repay this debt sits in a 2% bank account. Another is “blowing” a large sum, like an inheritance or tax refund, while earnings from a paycheck are more likely to be saved.
2. Anchoring – This is a common mental shortcut and can be defined as a “clinging to a fact or figure that should have no bearing on your decision.” In other words, latching onto random numbers irrationally. Two financial examples are comparing a sale price to a manufacturer’s suggested retail price and automatically thinking that the sale price is a “great deal” and using daily investment media hype as the basis for investment decisions. The problem with anchoring is that people often ignore or discount new information that does not fit their pre-conceived opinions (e.g., “the stock market is risky”). Anchoring is particularly dangerous when people know little about a product or service being purchased and ignore valuable cues. Marketers are well attuned to the anchoring error and often use it to their advantage. The best ways to avoid anchoring mistakes are to comparison shop before spending or investing money and to talk to others before making a large financial decision.
3. Overconfidence – This is an over estimation of one’s abilities or knowledge. Investors often place too much emphasis on what they know, or think they know, based on personal experience. Two common examples are: confusing familiarity about a company or a product as a consumer with knowledge; and placing a high percentage of retirement plan assets in employer stock because you work there and think you know all about the company.
4. Choice Conflict- Research indicates that people make purchases more frequently when they have fewer choices because choices are a cause of great anxiety. “Decision overload” often results in inaction (e.g., failure to enroll in an employer 401(k) plan due to a multitude of asset class choices).
5. Status Quo Bias- This is the tendency for people to “stand pat” and not want to make a change. Making changes causes discomfort and fear. An example that combines both mental accounting and status quo bias, is not selling stock because it was inherited from your grandmother. There is both a fear of making a change (selling) and a separate mental accounting system for inherited money versus other assets.
6. Loss Aversion- Research with hypothetical examples indicates that people respond differently (about 2.1 times more intensity) to guaranteed losses than to guaranteed gains. Investors don’t want to realize a loss unless they absolutely have to and will often make decisions- or not decide- to avoid regret.
Behavioral financial experts like to caution that “money is money,” no matter where it is kept and where it comes from. In addition, it is important not to substitute personal experience for investment research or mistake a bull market for superior stock picking ability. Additional information about behavioral finance topics can be found in the book Why Smart People Make Big Money Mistakes, by Gary Belsky and Thomas Gilovich.
