Most of us don't have a perfect relationship with our money and the imperfections can be amplified due to emotional decision-making. It's hard to always be rational when considering our money and our own biases are often the culprit. So where do our behavioral biases come from? And what can we do to overcome them? We explore those questions below.
What Are Behavioral Biases?
A behavioral bias (or cognitive bias) is an illogical, psychological prejudice for or against something. Even though there are dozens of cognitive biases we each fall victim to, there are some common ones we see frequently.
For instance, confirmation bias illustrates that we tend to favor information that supports our beliefs rather than the most accurate information. Hindsight bias is feeling the way things played out was "obvious" AFTER it already happened. This is also known as "I knew it all along" syndrome. These biases are often triggered during feelings of emotion as our brains try to support or get rid of certain emotions.
Common emotions that influence how we spend and invest include:
In terms of investments, this could lead to decisions that impact your portfolio in the long run. For example, you may feel fear as the stock market drops and want nothing more than to sell your stock to avoid further loss. There are endless tales of investors doing this and then not buying back into the market and losing thousands of dollars (or more). Our biases are so strong that we make poor investment decisions even having heard stories like that multiple times!
On the spending side, emotional spending (sometimes nicknamed “retail therapy”) is another common practice influenced by behavioral biases. When you’re unhappy or upset, buying something new can make you feel better (at least for a little while).
You’re not alone in your behavioral biases, and you can take action to change those things that may be impacting your financial standings.
What Can You Do Instead?
Talk to a Professional
People presume that financial planners work exclusively with investments. Ask a financial planner what they do most and they'll say something along the lines of "I'm basically a financial psychologist". We help our clients make the right decision when emotions begin to cloud logical thinking. In addition to providing some perspective, talking to a professional before making decisions allows you to slow down and avoid making a knee-jerk reaction.
Thinking long-term is much easier said than done. Imagine thinking about the health of your heart at age 65 while you order a greasy hamburger in college! We usually know the consequences of our actions before we make them but the further that impact is from now, the more our minds minimize it.
Because of this, I ask my clients what money means to them. Common answers are "choices", "security", and "freedom" before having them replace "money" in a sentence. For example, "I'm going to use some of my freedom to buy a car I want today resulting in less freedom in the future". It tends to keep our minds focused on the long-term when we think of it in a novel way.
Being self-aware is an important step in avoiding behavioral biases when it comes to investing. I always tell my clients that the best portfolio strategy is the one they are able to stick with. Working with an advisor to identify what you are comfortable with helps set you up for success by keeping emotions under control.
Acknowledging and controlling your behavioral biases can help you feel confident in your investment decisions and everyday spending choices. Working with a trusted financial advisor allows for objectivity and perspective during times that feel stressful.