Do you know why you make the choices you do when it comes to investing? I’m sure you could look back on some of your past investment decisions and wonder what in the world were you thinking. While some of us beat ourselves up over poorly made decisions, the reality is that it isn’t all your fault. Thanks to behavioral finance, we now understand why we make the choices we do.
Now you might be thinking what behavioral finance is and how you can improve your decision making process and use behavioral finance to your advantage.
Well in this post I am going to show you how. While you probably will still make some dumb mistakes, by understating behavioral finance, you will make fewer bad choices and as a result, keep much more of your money.
What Is Behavioral Finance?
Behavioral finance is an attempt to combine conventional finance and economics with cognitive and behavioral psychology to explain why people make irrational decisions.
You might read that a few times and still not understand it. In a nut shell, behavioral finance is looking at why we make irrational decisions even though we as humans are rational creatures.
For example, most people want to make more money. So we work jobs and save money to grow our wealth. But even though we do these rational things to grow our wealth, we still make irrational choices that hold us back.
These choices include playing the lottery when we have a fraction of a percent chance of winning. Another choice would be how we ignore the fact that we are more likely to get disabled than die young, but we ignore this and buy life insurance over disability insurance.
The grandfathers of behavioral finance are Daniel Kahneman and Amos Tversky who have conducted much research and authored many studies on this phenomenon.
Here are a few concepts these authors use to explain behavioral finance:
- Anchoring: this is when we use a reference point to anchor our beliefs, even though the anchor has no credibility. For example, some investors buy stocks that have fallen dramatically in value thinking they are a steal. The anchor here is the higher price of the stock. The investor sees this price as the stocks true value even though there are factors as to why the stock price dropped.
- Mental Accounting: this is when we separate our money in our minds with the result being that we keep ourselves in our current financial situation longer than otherwise needed. For example, many people try to build up an emergency fund while they are in debt. This makes zero sense financially since the debt is costing you much more money than the interest you are earning in the savings account.
- Confirmation Bias: this is when we subconsciously seek out information to prove our current beliefs. This skews our decision making process.
- Hindsight Bias: this is when we look back at a past event and are certain the signs were obvious at the time when in reality they were not.
Of course, not everyone is in line with their thinking. One prominent proponent is Eugene Fama. While he does admit there are times when humans make poor decisions, the markets are efficient and as a result, there is no such thing as a trend of human irrationality.
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How to Overcome Irrational Decision Making
Regardless if you believe in behavioral finance or not, the fact is we as humans make irrational decisions all of the time. In order to improve our finances, we have to improve upon the choices we make by decreasing the likelihood of irrational decisions.
How do we do this? There are a few steps to help us, including:
- Get all the information: don’t just look for information that supports your beliefs. Seek out information that contradicts it and put all of the information together to make a smarter decision.
- Keep emotions in check: we never make wise decisions when we are in an emotional state. As a result, we need to understand when our emotions are driving our decisions. The more you can sit back and calm down so you can think with a clear mind, the more likely you will be to make smarter choices.
- Take your time: I touched on this with the point above, but here it is again. Take your time before you make any decision. Collect all information, wait for your emotions to not factor in, and allow yourself to think clearly about the issue. The faster we make decisions, the more likely we make the wrong one. Don’t give in to the pressure and take your time when making decisions.
Overall, understanding behavioral finance can help you greatly in making better choices and keeping more of your money.
Just by reducing the number of poor decisions you make can have a major impact on your wealth. For example, the fewer irrational decisions you make, the more money can keep invested in the stock market.
The more of your money you keep invested, the more it can grow and compound upon itself, leading to even more wealth.
So be sure to follow the tips above to limit the number of times you make irrational decisions.