Today, I want to talk about the psychology of money, or what’s known as behavioral finance. If I’m going to teach you how to take control of your personal finances (your cash flow, your risks, your investments, and your distributions), you must know why you lose control of them. You see, the way you think about money directly affects the way you behave with money. Your personal beliefs and your unique experiences create your biases about life and about money. Those money biases affect your feelings and expectations about money which then lead you to handle money a certain way.
“The way you think about money directly affects the way you behave with money.” – Justin Goodbread, CFP®, CEPA®, CVGA®Click to tweet
The way you think about money directly affects the way you behave with money. Typically, if your emotions affect your actions, then you are going to react or act irrationally with money rather than rationally. As Brad Sherman with Investopedia says, “The concept of behavioral finance helps us recognize our natural biases that lead us to making illogical and often irrational decisions when it comes to investments and finances.”
So today, I want to discuss 19 different money biases that we formulate just by living life. Our experiences have shaped us and formulated our ideas about money, but those biases could hurt us, too.
Number one is an affinity bias, and that is the preference to invest in companies, organizations, or people who share our values. Oftentimes, here in the Bible Belt, people will not invest in certain areas because of their religious preferences. They may decide not to buy anything that deals with alcohol or tobacco. On the flip side, others will not put their money into religious organizations. That’s an affinity bias.
Second is the anchor bias, the reliance on a statistically arbitrary anchor point or numbers to make a financial decision. For example, you are familiar with your hometown. Thus, you’re only going to buy real estate within your hometown. That’s an anchoring bias. Similarly, maybe you pay $4 more for pet food at one store because you’re more familiar with that store than you are with others.
Typically, I see this next bias when it comes to sports, but it works the same way in the financial world. A bandwagon bias is the tendency to follow the crowd’s financial actions even if the crowd is following a different financial plan than you are. Most often, I see this with stocks. If news media mentions that a certain stock is doing well, then all of a sudden, everybody wants to buy it. I actually saw this in 2018 with the rise and fall of Bitcoin. People jumped in when they heard about it on TV. They bought in at $18,000 – $19,000, but now the stocks are only valued in the $3,000 – $4,000 range. That’s a bandwagon bias.
Another type of money bias is confirmation bias. This is the tendency to focus on information that confirms your first impression, your preconceived notions, or your beliefs and to ignore or devalue information that contradicts those things. In this bias, people only want to hear what people they agree with have to say. Recently, I had a client tell me that he wanted to spend $50,000 on his house to make certain improvements. He said, “I am confident this is going to increase the value of my house. Don’t you agree?” In fact, I didn’t agree. Yet, because I didn’t agree, the client refused to hear any of my suggestions.
Next is an endowment bias, which is the tendency to value items and assets more once you own them than you do when you are renting or borrowing them. I often see this in stocks, too. Many investors “love” buying stocks of the companies they work for. Yet, when they retire, many will not invest in those stocks anymore because they feel no ownership in the companies.
A familiarity bias is the preference to invest in familiar or well-known companies rather than doing research on ones with which you are not as familiar. If you’re familiar with a brand name, then you’re probably not going to try to find or do research about a competitor’s product or company. Chances are, you’ll buy or invest in a product with which you’re familiar.
Then, there’s the framing bias, which is the tendency to make decisions based on the way the information is presented rather than on the information itself. I call this “buying into the sales pitch.” Rather than thinking holistically and critically about the bigger informational piece, you allow the way someone presents a sale to persuade you to invest a certain way or to buy a certain product.
A bias I find fascinating in the financial world is the hindsight bias. This is the belief that you either predicted or could have predicted past events, so you were “always right.” In the Fall of 2018, if you had this bias, you were the one saying, “Oh yeah, I knew the stock market was going to drop.” Or, maybe you’re the investor saying, “I knew I shouldn’t have bought that particular thing. I just knew it!” That’s called a hindsight bias.
Look, friends, there are many things I’ve learned I can control. Yet, there are more things I’ve learned that I can’t control. In reality, I cannot control the results of an investment. I cannot make an investment do well or meet my expectations. However, the thought that you can control investment outcomes is called the illusion of control bias.
I often see clients who lived through the 2007 to 2009 economic crisis have a loss aversion bias. Many of these people have a desire to avoid taking risks that could bring about loss or negative outcomes even if the potential gains could be greater than the losses. You may have seen parents or grandparents stash cash all over their houses instead of putting their money into the bank or into investment accounts. If they lived through the Great Depression, they probably had a loss aversion bias and were doing whatever they could to keep their money “safe.”
In my experience, most people have this next money bias – the mental accounting bias. It’s the tendency to separate and group assets into separate mental accounts even though money is money, regardless of its use. For instance, you look at the money in your checking account, your savings account, and your investment accounts differently. Even though it’s all money, you tend to think about the money in the accounts differently and separate their uses in your mind.
Then, there’s the outcome bias. This is the tendency to make financial decisions based on the outcomes instead of the processes that brought about the outcomes. People tend to look at what they want to have happen, but they don’t pay attention to what will bring about the outcome. They want the quick fix or the large return on investment, but they don’t realize everything involved to attain those results.
Some of you may have an overconfidence bias, which is the unsubstantiated faith in your own judgment, reasoning, and analytical abilities when it comes to making financial decisions. Whether you have a financial degree or not, many of you believe you can time the market or play the market better than the experts. Even the experts can’t predict what the market will do! Honestly, I have a hard time working with people who have an overconfidence bias.
Many of you investors are still reeling from stock market losses October 2018 through January of 2019. Thus, you’re following a recency bias when you make financial decisions. In other words, you’re making financial decisions based on recent events rather than on events that happened in the more distant past. You’re ignoring past stock market gains and only looking at the losses.
Those of you who have a loss aversion bias also tend to have a representative bias. This is the tendency to classify financial events, decisions, and outcomes based on past experiences. Again, think of the events from 2007 to 2009. The stock market went crazy, and now, many people are sitting on their cash. They’re saving money instead of investing it because of their experiences in 2007. Yet, these individuals missed an unbelievable rally of some 200 – 300%, depending on the index, in the following bull market.
Then, there’s the self-attribution bias. Much like the overconfidence bias, the self-attribution bias is the tendency to attribute successful financial outcomes to your own talents, skills, and actions and to attribute unfavorable financial outcomes to external factors. Don’t we all do this to some extent? We like to take credit for the good, but we like to pass blame for the bad.
The reason I do not manage my own money is the self-control bias, which is the tendency to act in opposition to your best interests because you lack self-control. I have self-control. However, money is emotional to me. Therefore, I sometimes make irrational decisions when it comes to my own money. I have a tendency to sell low or to try to fix something. I’m sure many of you act the same way when it comes to your own money.
Because humans typically don’t like change, there’s also a money bias called the status quo bias. This is the preference to keep your financial status as-is in order to avoid change of any kind. Typically, investors want to be middle of the road. You don’t want to get too aggressive; you’d rather stay status quo. Even if an opportunity comes along, you tend to stay where you are or stay inactive because it’s easier to keep-on-keeping-on than to change.
The final money bias I want to talk about is the trend-chasing bias. This is the tendency to make financial investments based on their past performance, thinking that past performance indicates future performance. I often remind my clients that “past performance is not indicative of future results, and any advice or statements to the contrary are federal offenses.” However, I see many of my clients chasing the TV trends to “flip” houses or invest in rental properties because it’s “all the rage.”
By identifying the biases you have about money, you can build financial strategies to neutralize your emotions during stressful periods. In a sense, you can put up financial guard rails. In order to take control of your cash flow, risk management, investments, and distributions, you must be able to act and react rationally rather than irrationally. You cannot allow emotions to drive you, but here’s where it gets difficult… You have to act rationally over a long period of time. Building wealth is not a sprint. Sure, you’ve heard of the get-rich-quick schemes. Yet, the fact is that money comes easy, and money goes easy. An old Chinese proverb says, “If you get it fast, you lose it fast.” Most likely, you don’t want that. In order to build a long, sustainable positive net worth, you have to run a marathon, not a sprint. Therefore, you cannot succumb to your own biases when it comes to money.
Be sure to join me in my next blog about why your personal budget matters more than your business budget!