Behavioral finance is the study of how our behaviors affect our finances.
In many ways, the way that we see the world, and our reactions to what is happening around us, define our finances.
We might not even realize how our biases affect our finances.
The first step to overcoming biases in your life, especially if they are psychological, is to acknowledge them. You need to be aware of what is holding you back.
Once you recognize the reasons for your difficulties, it will be easier to address them — and to come out ahead with your finances.
Here are 6 behavioral finance mistakes that might be holding you back:
1. Confirmation Bias
One of the most dangerous biases is confirmation bias.
Confirmation bias is the tendency to seek out information that confirms what you already believe. Rather than consider opposing viewpoints, or look at contrarian possibilities, you filter out the unpleasant facts that don’t confirm your world view.
If you do allow in an opposing viewpoint, you either dismiss it quickly, or you rationalize it.
Why this is bad for your finances…
Selective information gathering can be a serious issue for investors. If you only pay attention to information that confirms what you already believe about an investment’s viability, you might miss important clues that indicate the asset’s imminent demise. Focusing only on information that cements your preconceived notions about a financial decision, whether it’s the type of life insurance you decide to buy or whether it’s a “hot tip” from a relative, can lead to difficulty down the road, since you only become more entrenched in your worldview, rather than heeding red flags and changing course while you can.
2. Pseudo-Certainty Effect
This is an interesting behavioral finance problem that manifests when you are trying to decide how much risk you can handle.
Basically, this effect encourages you to act exactly opposite to what you should when determining risk.
With the pseudo-certainty effect, you are likely to limit your risk exposure during times when things are going well.
Why this is bad for your finances…
You feel as though you are ahead of the game, and you don’t want to risk your position. So you hunker down — and miss out on potential opportunities.
On the other hand, the pseudo-certainty effect can also affect you if you are in a precarious position. However, rather than seeking stability, you tend to take on more risk.
Investors suffering from the pseudo-certainty effect will take bigger risks with a losing portfolio, sure that they can “get it all back.” Another manifestation might be the feeling that things are all going downhill anyway, so you might as well just spend, spend, spend. Many people in difficult financial circumstances find themselves plowing ahead with risky financial decisions, even if it lands them in bigger trouble.
3. Hindsight Bias
They say that hindsight is 20/20.
Indeed, when looking back on past events, many of us feel that the direction of the time seemed obvious.
Part of hindsight bias is the tendency to look for links and patterns that may not actually exist.
Once we build these patterns up in our minds, we feel as though we really were able to “predict” whatever event took place. This is especially true when it comes to market crashes and rapid gains. Looking back, we see the connections, and then proclaim that we “knew it all along.”
Why this is bad for your finances…
Even though the event might have been completely unpredictable, hindsight bias might lead to believe that, not only was the event predictable, but that you actually predicted it.
One of the possible side effects of this bias is overconfidence.
Your ability to pick out the patterns that predicted a major financial event creates a situation in which you think that you are more perceptive than others, and that you see what others do not. This might create a situation in which you are confident about your ability to pick stocks, or make other financial decisions.
When combined with confirmation bias, hindsight bias can be especially harmful to your finances, since you think you are seeing clearly, and you only pay attention to information that supports the idea that you are right.
4. Illusory Superiority
My husband has a Ph.D. in psychology. He once told me of a study that found that most people rate themselves as “above average” when it comes to intelligence. We are inclined to overestimate our genius and to underestimate our negative qualities.
As a result, we think that we are smarter than we really are.
Illusory superiority can also have the effect of encouraging you to take credit for outcomes that you might not be able to control when the result is positive. When the result is negative, however, the tendency is to place blame on external factors.
Why this is bad for your finances…
A good example is in the way you might pick stocks. If the stock does well, you claim that you are a stock picking genius. You might not be; the market might be doing well, so all stocks are gaining. However, the success is attributed — perhaps more than it should be — to your own skill.
On the other hand, if you pick a stock that loses, you might be inclined to blame other factors, such as a drop in the market, a recent scandal, or some other difficulty.
If you continue to feel that positive outcomes are entirely your doing, it’s easy to develop overconfidence in your abilities. At some point, though, this can lead to a big mistake that is harder to recovery from.
5. Availability Bias
This behavioral finance issue comes into play when you put greater emphasis on the latest information.
So, your opinion of a particular style of financial management might come because it’s the “latest thing.”
Why this is bad for your finances…
When the Debt Snowball came out, many people jumped on board because it was considered “new” in the way it spread throughout the personal finance sphere. Many people were very exuberant about it, even though the Debt Snowball isn’t as efficient at getting rid of debt as the time-tested technique of tackling the highest-interest debt first.
Another way that availability bias can affect your finances is through investing.
The latest news about a company can prompt overreaction from investors. The latest information is weighted heavily, whether it’s a somewhat disappointing quarter or whether it’s the launch of a new product. Rather than letting the latest news sway your opinions, it often makes sense to take a step back and look at the underlying fundamentals of an investment. Sure, the latest quarterly report might be a little depressing. But are the fundamentals still strong? Will the company likely weather the recent storm that caused the disappointment?
Reacting immediately to the latest information can lead to poor decision-making when it comes to your finances — especially when it comes to investing.
It’s important to take a step back and not overreact to the latest information that comes your way.
6. Impostor Syndrome
This issue isn’t necessarily related to finances all the time, but it can impact what happens with your money.
Impostor syndrome (sometimes called fraud syndrome) is the idea that you don’t deserve your success, or that you don’t know enough to proceed.
It’s this idea that you aren’t “good enough,” and that someone is going to “figure you out.”
Why this is bad for your finances…
When it comes to your career, this can be a real stumbling block.
You might not seize opportunities for advancement, or you may hesitate to ask for a raise, because you don’t want others to figure out that you don’t “deserve” it.
This might also hold you back in other ways, since you might feel as though you can’t make the “right” investing decisions, so you hold off. Even the idea that you aren’t a good money manager, and that you will only mess things up can slow your finances down.
While you don’t want to turn your impostor syndrome into illusory superiority, you do need to find a balance.
Last Word on Behavioral Finance Issues
We tend to think we are different than what we are. At least this is what these behavioral finance issues are telling us.
Before you make that next financial decision ask yourself why you are thinking the way you are. If you can recognize some of your biases, and work to overcome them through financial education, and a knowledge of yourself, you will likely find financial freedom much more successfully.
Your Turn
Which of these behavioral finance issues have you fallen victim to? Let us know your experience in the comments!
Nice post Miranda. Many of us who provide financial advice to clients deal with all of these at one time or another with clients. Numbers 2-3 are very prevalent and a clear aftermath of the 2008-2009 financial crisis and the ensuing stock market downturn. Far too many investors are “fighting the last war” so to speak to their likely financial detriment.
I like that term – “fighting the last war” Roger. I’ve heard people say “why bother investing” and refer to all the troubles the market had in ’08. But that was actually quite a while ago now and the market as a whole has grown.
Behavioral finance is a very interesting topic. Have you read Jason Zweig’s Your Money and Your Brain?
Confirmation bias is dangerous not only for finances, but in general. Many people who watch conservative or liberal news media only, have their biased beliefs pounded into them by the media. It then becomes nearly impossible to change their minds. They become puppets of the media.
And yes, I am above average. 😉
I’ve gotten through most of the book. I really need to take another look at it (it’s been a while).
Totally agree on the media. There’s so much polarized “opinion” out there.
You too? I think everyone that reads Free From Broke is above average.
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I see so many people struggle with “impostor syndrome” and use the excuse of not knowing what to do as a reason to do nothing at all with their money (except spend it).
Very interesting issues indeed! I fall ill to the Imposter Syndrome just about sometime every week, haha… Especially when it comes to blogging. When the good times are good – you feel like a rock star! When things look dreary for a hot second, you’re all of a sudden a fraud. The nice thing though is that it’s all in your head and usually not told out loud to everyone 😉 Except for when you leave comments on other people’s blogs out it (d’oh!).
No worries J, I won’t tell anyone.
That’s one of the best blog posts I’ve gone though in a long time. Looking at the personal finance ideas in such a manner is something unheard of, at least for me. The behavioral aspects that we have is very significant. We usually have prejudices and preconceived ideas on investing. Sometimes we are certain about some of our investments but it comes out to be a complete non-sense, leading to loss. After reading this blog I now know what are the different wrongs we do. I hope these ideas will help me make my financial decisions better.
No 1 is definitely something I think a lot of us are guilty of sometimes with a lot of things. We want that option, think we know it all already or have decided already so we just confirm what we think. We fail to dig deeper. Very dangerous in a lot of scenarios but especially when dealing with your money.
Great article, Miranda! Although investing does need a little tweaking here and there along the way, It’s important to stay grounded and not lose your head when things seem to be going either really well or downhill, like you mentioned in the Pseudo-Certainty effect section. Investors should be willing to take more risk when their portfolio is going well.
No 1 is unquestionably something I think a considerable measure of us are liable of infrequently with a great deal of things. We need that alternative, think we know it all as of now or have chosen as of now so we simply affirm what we think. We neglect to burrow more profound. Extremely risky in a considerable measure of situations yet particularly when managing your cash.
I love articles like this detailing our little behavioral quirks that hold us back or down without us realizing it. I especially pay close attention the first, Conformation Bias. It is all too easy to follow everyone else within our circle of influence and what appears to be the right and only way to go. I constantly try to question and look outside for my comfortable circle for any different point of view or possibilities. As an early retired Engineer and Analyst my Black-Hat thinking kicks in before making any kind of move.
Illusory Superiority is the most common I see. People all believe there live in Lake Wobegon, where everyone is above average. Great argument why people dont understand active management doesn’t work on average
Glen these finance mistakes are very interesting. I haven’t heard about most of these before.
I personally think that a lot of people play a bit too safe for the goals they want to achieve when it comes to finance. That’s actually why they need to have a professional advisor to push them to take risk within their ability. Not to the point that they would lose a significant amount of their resources, but enough so that they can see some decent profit after a few years of investments.
Also, the roles of age in making financial decision & role of emotional intelligence creates great impact on people dealing with their finances.
Very nice and informative article , thanks for sharing.