How To Use Behavioral Finance Theory to Make Better Financial Decisions

6 MIN READ

Investing and saving means more than understanding how to buy stocks or open a savings account.

Understanding behavioral finance is the key to learning what drives your investment decisions and how to avoid losing money from mistakes that may have been avoided.

What Is Behavioral Finance?

Not to be confused with behavioral economics, behavioral finance theory studies the psychological influences on investors and financial markets.

It's studied to understand the inefficiencies and mispricing in financial markets. It also focuses on why investors make rash decisions and sometimes act against their own interests.

Is Behavioral Finance a Science or an Art?

Behavioral finance is a science that focuses on why investors make their decisions.

It studies why investors delay investing or sell investments prematurely even if they know they shouldn't. It focuses on psychological factors that sometimes lead to irrational decisions.

How Effective Is Behavioral Finance?

Behavioral finance is relatively new, and there is still much to be researched and implemented to improve the financial health of consumers and businesses regularly.

It tends to consider more realistic factors than traditional finance, which assumes that every investor is logical and makes decisions based on unbiased information.

Reasons Why Behavioral Finance Is Important

So why is behavioral finance important? Here's what it affects the most.

Improved Decision-Making

Behavioral finance concepts consider how emotions and cognitive biases affect investment decisions.

When you understand why you have personal biases or make investment decisions that go against typical financial expectations, you're more informed and can make better financial decisions.

Market Anomalies and Inefficiencies

When robust market anomalies, like severe recessions or housing bubbles, occur, you can better understand the reasons and predict what might happen.

Understanding these market behaviors may help you make better investing decisions.

Risk Management

When you understand behavioral finance, you are better able to take risks that feel good to you.

You'll understand the risks you take and why. You can also take more risks when realizing why you restrict yourself to certain investing decisions.

For example, familiarity bias may restrict you from buying a stock or mutual fund from a company you know and trust versus diversifying and trying something new.

Long-Term Investing

Long-term investing is the key to earning investment gains. Short-term investments are volatile and usually require 10+ years to ride the storm.

Self-control and understanding behavioral finance can help you reach your financial goals faster.

The Influence of Behavioral Finance on Financial Decision-Making

Behavioral finance concepts study many factors investors consider when making decisions. Understanding the different biases can help you make financial choices that help you reach financial growth.

Understanding Cognitive Biases

Cognitive biases can occur in many ways, including believing the following:

Only skilled investors tend to do well, and anyone who loses money has bad luck.
Only information that confirms your current beliefs, ignoring anything else.
Having a quick and irrational reaction to something presented to you without researching it.
Going out of your way to avoid loss, you step over investment gains.

Risk Perception and Tolerance

Risk perception and tolerance may not be observed when there are biases involved in investment decision-making. The perception could be so off that it causes a bad investment decision, causing investors to lose money.

Investor Behavior

Becoming too confident or excessively optimistic can lead to poor investment decisions. These factors often lead investors to make irrational investments versus thoroughly researched investments.

Common Behavioral Finance Biases

There are many known biases that you may have, but here are the common ones:

Overconfidence Bias

People with an overconfidence bias think they know more than they do and are less likely to use herd behavior. Rather than following others, the investor tends to do whatever they want, no matter how irrational.

Confirmation Bias

Sometimes, investors tend to get stuck on one piece of information, and they focus on it. This could be from an influential source or a friend. But when that information is what they believe, they refuse to make any other investment decisions.

Loss Aversion Bias

Not looking long-term and focusing on avoiding loss can cause investors flawed thinking. This can cause investors to miss great investment opportunities.

Anchoring Bias

Some investors focus on the first price they hear about an investment, and that's how they base all future decisions on it, even if the numbers aren't accurate.

Herd Mentality Bias

Herd behavior occurs when investors blindly follow what others are doing without doing their own research. This starts a trend with more people doing the same thing for fear of missing out or doing something wrong.

How To Overcome Behavioral Finance Biases

Once you know your biases, you can act on overcoming them.

Awareness and Education

Be aware of your investment biases and do your best to work around them. Do as much research as possible, and consider trying new investments as you learn new techniques and get more confident.

Create a Decision-Making Framework

Try to avoid rash decisions by creating a decision-making framework. Set parameters regarding when you should or shouldn't sell investments, rather than just following what many investors do or reacting out of other irrational fears.

Consult With a Financial Advisor

Working with a financial advisor can be a great way to ensure you avoid your biases.

Financial professionals are trained and educated to help investors from different walks of life and values make the best investment decisions for their goals.

Related Article | 15 Questions to Ask Financial Advisors

Emotional Discipline

If you know your emotions will get in the way of solid financial decisions, set parameters, or consider accountability from a financial professional.

Have someone else to bounce ideas off before acting in predictable ways and letting your biases harm your investment decisions.

Set Clear Financial Goals

Setting financial goals gives you something to work toward and may help you make more rational decisions versus irrational ones.

So instead of dumping stock because it took a hit, you might think long-term, focusing on your financial goals and waiting it out.

Real-Life Examples of Behavioral Finance in Action

Seeing behavioral finance in action may help you better understand how recent events or your thinking can cause you to make bad investment decisions.

The financial crisis of 2008 is a good example. Many investors sold all their stock investments and had a bad taste in the stock market.

However, they carried it forward rather than letting it be a one-time feeling, limiting their future investments and financial gains.

Here's another example.

A company has a lawsuit brought against them. This makes investors panic because, in the past, lawsuits have caused stock prices to fall. This causes a mass exodus of the stock, causing its prices to fall further.

But it doesn't stop there. Investors worry that there will be further lawsuits in other companies within the industry, so they sell those stocks, too, causing their share prices to decline even though they had nothing to do with the lawsuit.

What Are the Benefits of Consulting With a Financial Advisor To Navigate Behavioral Finance Challenges?

Talking to financial professionals before making decisions is always a good idea.

Not only will you ensure you aren't falling prey to any behavioral finance challenges, but you'll also ensure you have factual information and aren't just using herd behavior.

This also helps eliminate errors made because of certain circumstances that make you believe information that isn't factual.

Related Article | What To Ask a Financial Planner

Conclusion

Learning to invest and analyzing your decisions can be daunting, yet it's essential for making sound choices.

Understanding your issues and finding the proper help can help you make investing decisions with the desired effect.

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