Understanding Behavioral Finance: The Psychology Behind Financial Decisions

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Introduction

Financial decisions are a part of everyday life, from small transactions at a supermarket to the buying and selling of company stock. Making decisions that help increase overall wealth is a skill that is often overlooked. Many believe that knowledge of stock trends or expert analysis is enough to justify making important decisions. These claims completely disregard behavioral finance, which studies the psychological factors that influence financial behavior.

Behavioral finance explores how cognitive bias, emotion, and social pressure lead to decision-making that is not always rational. Psychology gives good insight into why humans are imperfect, and understanding and improving psychology is critical to making accurate decisions, building wealth, and forecasting personal finances.

Behavioral finance incorporates areas of traditional fiannce, economics, and psychology

Although most prevalent in the individual, overconfidence in the market from corporations can affect the market as well. The 2008 financial crisis, for example, showed how the overconfidence of banks and fear of investors contributed to economic instability. These banks overlooked data and trends because of their belief that the US markets were infallible, and by letting opinions and emotion make decisions, their risk multiplied and the market ultimately collapsed. This is a perfect example of behavioral tendency creating a difference between data suggestions and market performance.

What Is Behavioral Finance?

Behavioral finance analyzes the reasons that a person’s financial decisions deviate from rational calculations offered by models or data. In these models, people are expected to act perfectly rationally; however, in the real world, investors and consumers also incorporate emotion and habits when making their decisions. Overconfidence before market collapses, skepticism leading to market stalling, and fear of collapsing banking structures are all patterns that emerge on all scales all around the world.

External factors can also affect spending and investing habits. Budgeting on a small income without leaving money for savings puts additional pressure on a consumer, potentially causing them to leave the stock market altogether.

Collective speculative behavior and media misinformation creates inflated market prices bound to collapse, as seen with the dot-com bubble in the early 2000s, where tech stocks with narrow profitability margins boomed. Under an emotionless investor, the price to earnings ratio would be enough to steer them away. However, this is not what happened: instead, the investor was captivated by a supposed impending technology boom that may see prices soar.

The dot-com bubble was a period in the early 2000s when tech stock prices soared unrealistically due to hype, only to crash when many companies failed to make profits

The decisions of these investors were influenced by emotion, not rationale. That is the impact psychology has on human decisions.

What Biases Affect Our Decisions?

Almost anything has some effect on a decision, but some patterns emerge when analyzing the causes of emotional volatility. As discussed, overconfidence is one of the most prominent causes of behavior changes in investing, especially from the corporate side.

For consumers, though, another psychological idea that has recently caused emotional decision-making is anchoring. When people see a claim or a trend at first glance, their first reaction to the data has high correlation to their investment decisions and personal planning. After deciding whether a trend is positive or negative, human psychology prevents this decision from being easily changed, even if it is objectively wrong.

Anchoring bias is when people rely too heavily on the first piece of information they see, even if it's not accurate, to make decisions

This has a large impact on personal planning for consumers, as more people are using short-term market trends to dictate their long-term retirement accounts. These deviations from portfolio stability are adding unnecessary risk and potentially lowering the value of their assets.

Another pattern that is visible, especially for new or inexperienced investors, is a herd mentality. Many people join the stock market with hopes of quickly returning a profit by following an investment strategy of a friend, colleague, or private equity firm. Creating waves of buying and selling in this fashion not only increases intrinsic market risk to the investor but also limits their knowledge and trust in their assets.

Psychological Tactics of Corporations

Corporations try to take advantage of these behavioral patterns to try and maximize their profit. Many advertise use framing techniques to maximize the appeal of their product by highlighting the benefit and neglecting the drawback.

Credit card companies, for example, emphasize their rewards plan and cash back for their cards without mentioning the high interest rates that come with them. This technique takes advantage of anchoring, as consumers will only retain the positive image of the product put forth by the company.

Chase Freedom Unlimited promoting no annual fee with no mention of the APR in bold.

In the investment world, corporations try to signal or create positive trends in their company. Stock buybacks are good examples of this, because the company buying its own stock signals to investors that the company expects itself to perform well. This brings those investors in with a herd mentality even though there is no data outside of the buyback to support that decision.

How to Overcome Behavioral Biases

By reading this, the first step to overcoming these biases is accomplished: awareness. Most people are unaware that they make biased decisions; in their mind, the decision is purely logical. The next step to creating a more reliable investment and financial planning process is to eliminate biased interaction. This means rejecting impulses after seeing advertisements, using numbers and tested software to analyze performance, and controlling spending habits on unnecessary items. A detailed financial planning process, including budgeting and retirement planning, can help easily categorize income and spending to prevent the influence of bias as well.

Behavioral finance reveals the profound impact of psychology and psychological manipulation on consumers and investors. By working to identify and counter positive and negative biases, investors can make more rational decisions to foster financial well-being.

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