We have a complex relationship with money. As a result, it’s hard to be consistently rational in how we use it. Where do our behavioral biases come from? What can we do to counteract them? We explore these questions below.
What Are Behavioral Biases?
Many of us set budgets, monitor our investments and savings, and spend wisely. In doing so, we like to think that we are acting rationally with our money. The truth is people are emotional creatures, especially when it comes to finances, and this may affect our decision-making.
Common emotions that influence how we spend and invest include:
In terms of investments, this could lead to decisions that impact our portfolio in the long run. For example, we may choose to “follow the crowd” due to FOMO (hellloooo, crypto!) or sell shares impulsively when stocks start trending down (like the past month).
Retail therapy (aka emotional spending) is another common practice influenced by behavioral biases. When we’re unhappy, stressed, or upset, buying something may make us feel better in the short term.
We’re not alone in our behavioral biases, and we can take action to change what may be impacting our financial standings.
What Not to Do
Although it may be tempting, we need to avoid making rash investment decisions based on what we see in the news or hear from friends and family (again, hi crypto!).
For example, we may hear that a CEO of a major corporation is stepping down because of a fraud allegation against him. In turn, our first reaction (perception) may be to get rid of our investment in that company. The CEO's resignation may not have any impact on the company’s long term performance. Instead of thinking about that company’s stock over the span of years or decades, we made an in-the-moment decision based on short-term changes. Our gut reaction was to protect our assets right now, but if we're saving for a goal that is decades away, like retirement, we may have hurt our chances for greater returns down the line.
What Can We Do Instead?
Talk to a Professional
If we know that planning our future spending and managing investments tends to be dictated by our emotions, consider working with a financial planner. She will be able to act as an educated, unbiased third party to guide us through investment decisions and other aspects of our financial life. It's like having a guide to navigate us through an ever-changing landscape.
It is paramount that we think long-term when making decisions, rather than following trends that will not be beneficial to us in the future. For example, the S&P 500 is down roughly 5 percent year to date. It hit a low of being down 9 percent around the last week of January. If we bailed on a downturn, it's like a store having a sale and the customers saying "no, I don't want to take advantage of the sale, I'll wait until things return to full price (or higher)." Sure, the price of the investments previously bought are dropping in value, however if we buy more of that investment at a lower price, it helps lower the average price of our entry point (cost basis).
Being self-aware is important in life and this awareness may help avoid behavioral biases when it comes to investing. We should assess our risk tolerance and allow that information to help determine our asset allocation strategy. Doing so should help alleviate some worry regarding our investments and reduce the urge to make choices impulsively.
Acknowledging and controlling our behavioral biases may help us feel confident in our investment decisions and everyday spending choices. Working with a trusted financial planner also allows an objective third-party to offer educated guidance and direction - without emotional bias.
This content is developed from sources believed to be providing accurate information. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security.