Financial Psychology: Understanding and Beating Biases
When I started my CFP training, the first topic we absorbed after the CFP Board Code of Ethics and Standards of Conduct was the Psychology of Financial Planning. Interestingly, before 2022, behavioral finances wasn’t a required topic of the curriculum. However, focusing on our attitudes, beliefs, and behaviors around money has been a massive trend in financial planning.
“Personal finance is only 20% head knowledge and 80% behavior.”
Why has this become so important? Because Behavior Affects Finances. Some in the personal financial world, like Dave Ramsey, have been proclaiming this for decades.
Now, let’s not get caught up in the specific percentages here. The point is that, as an example, we could teach you how to calculate the amount of money you need to invest monthly from here to your retirement to produce a specific amount of annual income, but if you don’t execute the actions, you won’t reach that goal. The calculation takes 5 minutes, but the discipline to get there takes years and decades. Life will have stressors that try to knock you off your game, and having this behavioral finance thing nailed down will draw attention to what hinders constructive action.
Today, I aim to uncover some of the most common biases and fallacies we see. You might have some lightbulb moments, and that’s fantastic. I encourage you to continue the conversation with your advisor or connect with us for the first time to explore your situation further. At the end of the article, I’ll offer a set of behaviors to combat these predispositions.
Identifying Money Mindsets
To understand the biases we face, let’s spend time considering examples so we can identify them. Awareness is a skill needed to halt or change behavior patterns. Here are my top twelve.
Analysis Paralysis: We look at the information presented repeatedly, studying it from every angle. We don’t want to make a mistake. The situation appears complex, and maybe a better option or timing will present itself soon. We can’t make a decision, so no action is taken. We have the overwhelming bias to do nothing and maintain the Status Quo.
Attachment Bias: We have sentimental reasons for our course of action, which is due to the close relationships we’ve formed. Most commonly, Mom and Dad had stock in their accounts that they had for, like, forever, and we couldn’t bring ourselves to sell them.
Confirmation Bias: We pay attention to information that supports our initial perspective and minimize or ignore contrary information. Let’s say we were invited to dinner and hear about an investment that touts positive returns and no loss of principal. It sounds so good that we are strongly swayed. We find blog posts encouraging us to make the investment, and contrary opinions are avoided outright or minimized when we see them.
Framing Effect: Decisions are based on the way information is portrayed. If a choice is shown positively, we tend to follow that option. If a direction has been framed negatively, we are hesitant or avoid that choice. It’s all in the presentation.
Herd Behavior: The crowd sways the psychology of my financial decisions. Cryptocurrency is an obvious trend in the world of investment at the end of 2024. As we read about the run-up in the price of Bitcoin and the vast number of people finally yielding to the excitement, we feel a strong pull to participate because we are afraid of missing out on the boom.
Inappropriate Extrapolation: Here, we assume recent events will continue. We see a pattern we believe predicts an outcome but really has no direct relationship. Say, for example, while watching Bloomberg News, we notice a pattern of three years of gains in the S&P 500 index followed by one year of loss, and the pattern seems to repeat. We might think that because the index had two years of 24%+ gains most recently, the market will be up again next year, and the following year, it will be down. Another term for this is the Gambler’s Fallacy.
Loss Aversion and Risk Taking: Loss aversion theory suggests that humans perceive losses as doubly painful compared to the same gain. For example, if I lost $1,000 in stock, I would feel exceedingly terrible, but if I were to gain $1,000 in the same investment, I wouldn’t get matching positive juices. This causes folks to keep losers on paper rather than realizing an actual loss (Loss Aversion) because we don’t experience the pain unless we sell. We might extend our gamble by taking proceeds from a winner and adding to the loser, hoping for a rebound (Risk Taking).
Sunk Cost Fallacy: What if I’ve spent a lot of time and money and stuck with a course of action? This theory says I will continue to pursue that same course of action because I don’t want to lose the resources (time & money) I’ve already invested. It’s a powerful bias to overcome because it requires that I realize I made a poor decision and choose a new path.
Overconfidence: Here, we find an outsized belief in our own abilities. For example, we might feel that way because we bought nVidia in 2017 when it started the year at $2.52/share, and now it’s skyrocketed at the end of 2024 to $135 and change. We base our future decision-making on similar convictions we had in the past that rewarded us.
Overreaction: This is an emotional reaction to market movement or eye-catching news, such as the outcome of a presidential election or the vision of a vocal CEO. In it, the belief is that the news of the day will cause or is believed to portend a big market swing. We quickly ensure we participate (or avoid participating if there’s a big loss expected).
Urgency Bias: In this error, we sense pressure or feel bullied into making a decision. We make an expedient decision to solve a problem because we think something else will go wrong if we don’t.
The “Only One Choice” Fallacy: In a given complex situation, we believe we have only one or two choices available. Usually, we set it up so that one choice is so bad that we have to take the other, or we only see one viable option from the start.
Smashing Behavioral Biases
Now that we know what some of these things look like, what techniques can we use to beat back biases and chart a calm course forward?
Be Self-aware: We are all susceptible to any of these biases and fallacies. Becoming aware of our tendencies is the first step in avoiding them. Otherwise, you’re bound to repeat them. In any situation, stop, be radically honest with yourself, and ask yourself if you’re operating under one of these pretenses.
Find a Trusted Advisor: Alright, I know I’m an advisor, so I might be charged that this is for my benefit. Be that as it may, the fact remains that wise counsel gives you an outside perspective and immunizes you from blunders. Enough blunders strung together create a serious drag on your financial goals. We may succumb to any one of the biases and fallacies without a competent advisor. These proverbs say it all.
“The way of a fool is right in his own eyes, but a wise man listens to advice.”
“Without counsel, plans fail, but with many advisers, they succeed.”
Slow Down: Take your time. When circumstances seem time-critical, use that as a deception detector. This helps us overcome the Urgency Bias.
Identify Options: Figure out all your available options. Smash the “Only One Choice” Fallacy with this technique. Generate three, four, or five options, and give each one a fair chance. Consider the advantages, disadvantages, and order of operation.
By the way, my favorite part of the Financial Planning Process is when, after we have understood your situation and analyzed your current position, we develop alternatives, meet with you to offer options, and empower you to choose what’s best for you. The Dala Group advisors are skilled planners who are in their sweet spot when working with you.
Gather Data & Facts: Use genuine data and facts from trustworthy sources rather than operating on conviction and intuition. For example, when evaluating investments, we look at a company’s assets and liabilities, as well as its cash flow and earnings growth. We want to determine a fair valuation. This is an example of how we use data and financial facts rather than trends and feelings when offering guidance.
“The one who states his case first seems right until the other comes and examines him.”
Listen to Contrary Opinions: Gather information from sources other than the ones you tend to favor and avoid Confirmation Bias. Keep this proverb in mind.
Consider It Afresh Today: Would you buy it if you didn’t already own it? If you answer no, it’s likely time to sell or move on. This helps you escape the Sunk Cost Fallacy.
Steer Clear of the Bandwagon: My motto is “Don’t follow the masses because the M might be silent.” (I taped this slogan to my computer monitor at home!). I recall a time two decades ago when a bunch of fellow co-workers were buying houses and depending on renters to make the mortgage payment. Some survived, but a few were under deep financial stress, and one or two lost their homes. We were all caught up in the house-buying mania and would have been better served buying when we could financially afford it based on our unique situation.
Create a Plan and Stick to It: Here’s the bottom line. When it comes to reaching your investment goals, slow and steady wins the race. Constant change to your actions creates unexpected drag. Here is a basic framework to begin with.
Invest based on your goals and time horizon.
Stay diversified by putting eggs in multiple baskets.
Pick investments and stick with them for the long haul.
Enhance your discipline with regular monthly contributions.
There are many more potential pitfalls to avoid, and specific actions we help you develop to get you where you want to go. We’d love to be that trusted advisor who guides you toward the picture you envision, and if you haven’t clarified what that vision looks like yet, we are skilled at helping you figure that out, too.
This commentary reflects the personal opinions, viewpoints, and analyses of The Dala Group, LLC employees providing such comments. It should not be regarded as a description of advisory services provided by The Dala Group, LLC or performance returns of any The Dala Group, LLC client. The views reflected in the commentary are subject to change at any time without notice. Nothing in this commentary constitutes investment advice, performance data, or any recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. The Dala Group, LLC manages its clients’ accounts using various investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.
