Behavioral Economics

[soupandstew]

I get a monthly newsletter from our CPA and the following was part of the December issue.  I found it thought provoking.  

The Psychology of Money: How Behavioral Economics Impacts Financial Decisions



People can have strange relationships with money. For some, it’s a powerful tool to get what they need. For others, it’s a necessary evil; something they have to contend with to live in this world. Some people want to accumulate as much money as possible; others believe that wealthy people must have done something bad to get where they are. The psychology of money and our relationship to it isn’t just fiction. It’s a genuine field of study called Behavioral Economics.



Behavioral economics combines parts of psychology and parts of economics to shed light on why people make the choices they do. An essential understanding is that people don’t always make the most rational decisions or the ones that seemingly would offer the optimal results. This is true even in situations where the person has all the experience and information to make the smartest decision. Often, money decisions are made based on emotions. Consider an example like a gambler, who knows the odds are against them, sees their stack of chips getting shorter, knows their bank account is nearly in the red, yet continues to place bets. The more you understand behavioral economics, the more control you may have over the way your personal relation with money influences your financial choices.



The Money Mindset



The money mindset is the way you think about money. When you think about money, how do you envision it? Do you feel like everybody else has money and no one wants to give you any? Do you feel like money is abundant in the world and all you have to do is step into the abundance? When you get money, does it instill a sense of fear or a sense of empowerment? Your upbringing, experience and your surrounding culture all play a significant role in how you perceive matters of money. It’s worth spending some quiet time thinking about how you feel and think about money. This is the first step in taking control over your financial decisions.



Loss Aversion



Loss aversion is a core concept in behavioral economics. It’s a kind of psychological bias where the pain of losing money is more strongly felt than the joy of gaining money. If a person has loss aversion, they may immediately get fearful when they come into money because they are afraid of losing it; so much so that it nearly overrides the pleasure of getting the money. Those with loss aversion tend to be very conservative with their money. They may avoid investments altogether, opting instead for a savings account, or even hiding money in the house. Their financial decisions are often driven by fear instead of logical reasoning.



Anchoring



Anchoring is a cognitive bias that appears in behavioral economics as well as other areas of psychological study. Anchoring is when a person anchors their choices on a specific reference point. The danger is when the reference point is no longer valid. In finances, a person may anchor decisions to how much their first paycheck was, or the value of an item when they first purchased it. For example, have you ever visited an elderly family member whose collection of Beanie Babies has taken over a guest bedroom? They’re anchoring their hoarding on the big financial bubble that Beanie Babies created years ago, when they first came out. Since then, so many Beanie Babies have been made that they will likely never be worth much more than retail. But that person can’t see that their decision is based on an anchor point that is now irrelevant. It’s important to regularly reassess anchor points to ensure they are still accurate in current economic conditions.



Herd Behavior



Herd behavior is more prevalent now than ever. From social media influencers to flashy money gurus, everyone seems to be “following” someone. Our natural instinct to be social means that we want to be part of a group. People tend to buy when and what everyone else is buying, and sell when and what everyone else is selling, irrespective of the underlying value of the asset. We all want a piece of the money pie. But herd behavior often leads to bubbles and crashes in financial markets. It can also lead to personal financial ruin. It’s not a good way to approach finances because everyone has unique goals and financial circumstances. While it’s important to stay abreast of market trends, it’s never a good idea to blindly follow where others lead, no matter how many other followers they have.



Sunk Cost Fallacy



This is a tendency to keep throwing good money after bad. In finance, it’s a behavior to continue investing in something because of the resources already committed, even when it no longer makes financial sense. In investment, this might manifest as holding onto a stock or asset that is continuously losing value. The person doesn’t want to admit that the original plan didn’t work. The previous investment influences the decision to remain committed, when in reality, the amount of previous investment is unrelated to the potential outcome.



Overconfidence



This is a cognitive bias reflected by overestimating one’s own abilities or intellect. In finance, it can manifest as taking exceptional risks, based on the belief that the person has a special talent that others lack. It may make a person believe that they can outperform the market. It can also manifest as an unwillingness to listen to sound advice, even when that person has paid for or requested the advice in the first place.



It can be exceedingly helpful to make efforts to understand one’s own relationship to money and to making financial decisions. One of the recommended paths to a better understanding is to talk to a CPA for unbiased guidance on tax-related matters. For more information, contact your CPA today.

[MN-Investor]

The Bogleheads' Wiki has an article about this subject which you might also find interesting.

Behavioral pitfalls

[soupandstew]

thank you MN-Investor.  That article was a good read and absolutely true.  I truly cringe when I see people staying 100% in cash because they are averse to any market risk.  IMHO they frequently guarantee themselves a loss as their interest earnings often fail to keep pace with inflation.  But, to each their own