Behavioral finance is the study of human behavior with respect to managing money. A growing field for the past two decades, it has been described as “part economics and part psychology.” When making decisions as an investor, beware of the behavioral finance error called “familiarity bias.” What this means is that people tend to invest in things that they know (or think that they know) and ignore investments that they don’t understand or have any experience with. An example can be found in a study of Regional Bell Operating Company (RBOC) investments by a Columbia University professor who found that investors were more likely to hold shares of their local RBOC than any others.
With familiarity bias, there is an over estimation of one’s abilities or knowledge, which leads to overconfidence. Overconfident 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 investment knowledge
• Placing a high percentage of retirement plan assets in employer stock because you work there and think you know all about the company.
As noted in an August 2010 Library of Congress Report, Behavioral Patterns and Pitfalls of U.S. Investors, “Employees already have a stake in the performance of their companies without including company shares in their investment portfolios. Not only does concentration in one asset violate the principle of portfolio diversification, but, if employees devote a large portion of their portfolios to their own company’s shares, they run the risk of compounding their suffering if the company does poorly; first, in loss of compensation and job security, and second, in loss of retirement savings.”
The above scenario is exactly what happened to employees at Enron in 2001 and Fannie Mae in 2008. They lost both income and savings when Enron filed for bankruptcy and Fannie Mae was placed into government conservatorship. Employers such as these have often been criticized for encouraging familiarity bias with employee stock ownership plans (ESOPs) and company matches on 401(k) plans.
Two additional behavioral finance errors are mental accounting and anchoring. Mental Accounting is where people separate their money mentally into different “accounts.” A dollar in one location is valued as more or less important as 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 be a cause of problems when “the big picture” of one’s finances is ignored. An example of a mental accounting error is carrying an 18% credit card balance when money to repay this debt sits in a 2% bank account. Another is “blowing” a large sum of money, like an inheritance or tax refund, while earnings from a paycheck are saved.
Anchoring can be defined as a “clinging to a fact or figure that should have no bearing on your decision.” The problem with anchoring is that people then discount new information that does not fit their pre-conceived opinions (e.g., “the stock market is risky” and “this item is on sale”). Anchoring is particularly dangerous when people know little about the product or service being purchased and ignore valuable clues. The best ways to avoid anchoring mistakes are to carefully comparison shop before spending or investing money and talk to others before making a large financial decision.
Many common investment mistakes (e.g., under-diversification) can be attributed to behavioral finance concepts. Thus, it is wise to understand behavioral finance errors and try to minimize or avoid them. Additional information about behavioral finance topics can be found via Internet search engines (e.g., Google Scholar has many scholarly research articles on this topic) and in the 1999 book Why Smart People Make Big Money Mistakes, by Gary Belsky and Thomas Gilovich.
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