Behavioral Biases in Personal Finance

While we would all like to imagine that we approach financial decisions with complete rationality, that is all too often not the case. There are times when it makes sense to rely on instinct to make quick decisions; after all, if we analyzed every little decision throughout each day, we would never get anything done. If the decision is between a sandwich and a wrap for lunch, maybe relying on gut instinct is appropriate so you can enjoy your meal and move on with your day. However, when it comes to financial decisions, it is important to acknowledge how easy it is to let biases guide us, even to our detriment. This article will review some of the most common biases applied to personal finance, with guidance on how to move past them to make sound financial decisions. 

Present Bias

When making a determination between what is good for our “present self” versus our “future self,” most of us will err on the side of the decision that benefits our present self. This is the core problem that many people face with insufficient savings rates. The immediate reward of a purchase today is usually preferred over the delayed gratification of saving that money for a future need (or want). There will always be a tension between balancing the current quality of life and future financial goals, and while the answer is different for everyone, it is important to seek a balance between the two. Working with a qualified financial planner can be a great way to have confidence in the fact that the probability of meeting future financial goals is high, which can then allow you to spend more freely on things that maintain or improve your current standard of living, knowing that you are on track to meet your future goals.

Loss Aversion

There is something in our psychology that is naturally more fearful of loss than hopeful about gains. Losing $10,000 hurts us more than the enjoyment we receive from a $10,000 gain. This can lead to poor financial decisions, such as holding on to losing investments simply because it is undesirable to realize the loss, or taking an overly conservative approach to your investment strategy at the detriment of earning sufficient long-term growth necessary to fund retirement goals. (Sometimes loss aversion, in the example of holding onto a losing investment, can be amplified by another bias (the Sunk Cost Fallacy), in which we not only hold onto a losing investment to avoid making that loss “real,” but also continue to invest more money into with the mindset of, “Well, since I’ve already put in $10,000, I might as well keep going to try to fix this.”) (With the Sunk Cost Fallacy, the amount that you previously invested should not skew your view of the current value, or the realistic future opportunities within that investment.) While losses are bound to happen throughout life, they can be mitigated by working with professional advisors, maintaining sufficient diversification, and using bucketing strategies to cover near-term expenses with low volatility assets (to name just a few). When losses occur, they can be leveraged to enhance your financial strategy. (Realized investment losses may be used to offset up to $3,000 of ordinary income, and if there are losses in excess of $3,000, they may be applied against realized gains to offset the tax impact of those gains.)

Status Quo Bias

As long as things are “okay,” we tend toward inaction. Even when things could be much better than they are, we tend to avoid the energy and effort it would take to make a change (oftentimes maintaining the status quo until something blows up, at which point we are forced to make a change). Some people will even take the initial steps of investigating a situation to see if there is a better alternative, but will become overwhelmed by the choices and the analysis required to make a change, and will simply give up and stick with the status quo. With limited time and energy, we all fall victim to the status quo bias on occasion. The important thing is not to let years go by in a sub-optimal financial position, simply because it’s easier than making a change. For example, you may feel as though your investment portfolio is not getting as much growth as it should be, but because it hasn’t blown up yet, you haven’t made a change. If, in fact, it is overly conservative, and the situation is allowed to go on for 10 or 15 years, the missed returns between the conservative portfolio and the appropriate portfolio – when compounded – can make a material difference. It is always worth a conversation with a financial professional to ensure that your strategy aligns with your goals and your risk tolerance.

Confirmation Bias

If you believe in Bigfoot or the Loch Ness Monster, and you go online to research it, you will probably find some evidence to corroborate your belief. In the age of the internet, we have unlimited information at our fingertips, and since we cannot realistically consume all of it, we tend to filter it into a more digestible form. Most of us would like to believe that we maintain strict objectivity in our research processes, but in filtering information, we often find or focus solely (or at least more heavily) on information that confirms or aligns with our pre-existing beliefs. For example, if you think that it is not a good entry point into equities because the stock market is at all-time highs, you would probably find mountains of information affirming how precarious the market is right now. You would probably end up ignoring all of the information that references how long the market historically spends at all-time highs, and how using that one piece of information to guide your entry point is insufficient and would likely lead to months or years of lost gains. It is important to continually strive to remain objective, take in information that supports both sides of the decision, and then make a decision that incorporates that information with equal weight. 

Herd Mentality

Investors falling victim to herd mentality can be traced back to the 1630s, when the value of tulips began to rise. As the value increased, more and more people jumped on the bandwagon and began buying tulips to avoid missing out, which in turn kept pushing prices higher. The problem with extreme momentum trades like tulips in the 1630s is that they can implode just as quickly on the downside as they skyrocketed on the upside. Those who are hurt the most from this behavioral bias are the investors who see the unreasonable valuations as the asset approaches its high point, finally fall victim to the herd mentality and buy at the top, and then continue to hold the investment (loss aversion and/or sunk cost fallacy) as it falls back to earth. It is important to work with a financial professional when selecting investments to help avoid making decisions based solely on the Herd Mentality.