Behavioral Finance

Behavioral Finance | Financial Education

Personal Finance

Personal finance is the use of financial management principles with respect to individual or family unit finances to manage money, budget, save and spend while taking into account various future risks and life events.

Behavioral Finance

Behavioral finance is a subcategory of finance that seeks to explain the rationality or irrationality of financial decision-making. It seeks to combine behavioral and cognitive psychology theory with finance to provide explanations for why people make irrational decisions.


Why Do We Make Irrational Financial Decisions?

Introduction

1. The plan is to introduce behavioral finance theory.

2. The goal is for you to understand how our decision making is impacted by psychological behaviors.

3. The takeaway is to know important concepts and become more aware of our financial decision making process.


Irrationality with Money

Are you rational with money? We’re NOT rational with money.

We all want to be wealthy and increase our well-being. We understand that we shouldn’t spend money we don’t have but emotion and psychology influence our financial behaviors in unpredictable and irrational ways.


Behavioral Finance

1. Anchoring

2. Mental Accounting

3. Confirmation and Hindsight Bias

4. Gambler’s Fallacy

5. Herd Behavior

6. Over Confidence

7. Overreaction and Availability Bias

8. Prospect Theory 


1. Anchoring

Attaching our thoughts to reference points that have no logical relevance to decision at hand.

– Diamond Engagement Ring

– Stock Valuations


2. Mental Accounting

A tendency to separate money based on subjective criteria often impacting financial decisions and wellbeing.

– Saving for vacation or home earning very little interest yet continuing to pay high interest rates on existing debt.

– Causes people to not use money efficiently such as “found money”


3. Confirmation and Hindsight Bias

Confirmation Bias

Selectively filter and pay more attention to information that supports our opinion while ignoring any thing that may dispute it.

Hindsight Bias

Believing that the onset of past events were predictable and completely obvious although outcome could not be predicted.


4. Gambler’s Fallacy

Belief that because of a series of events the likelihood of a random event will less likely occur.

– Flipping a coin and landing on heads 12 times and believing the next flip will be tales.


5. Herd Behavior

Mimic the actions of a larger group whether rational or irrational. Social pressure of conformity.

– Taking out student loans.

– General acceptance of credit cards

– Purchasing a home.


6. Overconfidence

Confidence implies realistic trust in one’s ability while overconfidence usually implies optimistic assessment of one’s knowledge and control over a situation.


7. Overreaction and Availability Bias

We overreact to recent news and give more weight to recent trends.

– Purchasing stocks because of recent good news causing price to skyrocket. Conversely, selling stock on bad news causing price to plummet.

Pick One 1. You have $1,000 and must choose between A or B. — Choose A) You have 50% chance of gaining $1,000, and a 50% chance of gaining $0. Choose B) You have a 100% chance of gaining $500.

Pick One 2. You have $2,000 and must choose between A or B. — Choose A) You have 50% chance of losing$1,000, and a 50% chance of losing $0. Choose B) You have a 100% chance of losing$500.

Majority of people will choose (B) for Question #1 and choose (A) for Question #2. ————– The right answers are either A or B for both questions. However, those choosing the answers above are more risk adverse.

8. Prospect Theory

Value gains and losses differently. Feel more pain in losing than joy felt in receiving equal amount of gain. Given two equal choices, one expressed in gains and the other in losses, people choose the gains although yielding the same economic result.

– Choosing not to save in a bank or refusing to work overtime.

– Selling winning stocks and holding on to losing stocks.

Is it okay to be irrational?

By understanding your mindset and behaviors, you can set up systems to account for the irrationality of our financial decision-making process.


Articles

+ Exploiting Behavioral Finance. Seeking Alpha

Manipulate Me: The Booming Business in Behavioral Finance. Bloomberg


Books

        


Resources

+ Introduction to Behavioral Finance. Investopedia