8 Toxic Behavioral Finance Tendencies

What is Behavioral Finance?

Behavioral finance is a fascinating field combining psychology and economics insights to understand how individuals and investors make financial decisions.

Traditional finance theory assumes that people are always rational and make decisions that maximize their wealth or utility. However, behavioral finance challenges this assumption by recognizing that cognitive biases, emotions, and mental shortcuts (heuristics) can lead to irrational decision-making in financial matters. Here is a list of expected behaviors and tendencies that can affect financial decision-making.

Common Behavioral Finance Tendencies

Loss Aversion Bias

This psychological and cognitive bias explains the tendency to avoid losses over acquiring equivalent gains. In other words, people are more likely to be risk-averse when it comes to potential losses than they are to be risk-seeking when it comes to potential gains.

The pain of loss is believed to be twice as powerful as the pleasure we get from gains. This tendency can lead people to abstain from investing in the market simply because they are concerned that they may lose value. This bias can lead to suboptimal decision-making when it comes to investing.

Anchoring Bias

This bias occurs when individuals rely too much on the first information encountered when making decisions.

When shopping online, the first price you see can set an anchor for comparison with subsequent prices.

Salespeople often use a technique to influence customers to make a purchase. They show customers high-priced options for a product or service, which creates a perceived value in the customer's mind. Then, they present the customer with lower-priced options. This exercise tricks the customer into anchoring the value to the first price they saw, so the lower-priced options appear as a bargain.

Herding Behavior

This behavior refers to the tendency of investors to follow the crowd, even when it may not be rational. This behavior can lead to groupthink and the fear of missing out, which can cause market bubbles and crashes.

People generally don't want to miss out when the perception is that everyone is following a particular trend. They may think others know something that they don't. They don't want to miss out even if their knowledge of the subject is limited.

During the mid-1600s in Holland, there was a phenomenon called the Dutch Tulip bulb market bubble. Tulip bulbs were considered a symbol of wealth, and it was believed that any man of fortune should own a collection of them. In fact, according to The Library of Economics and Liberty, "it was deemed a proof of bad taste in any man of fortune to be without a collection of [tulips].”(Goldgar, 2008)

The perceived value of Tulip bulbs was due to the time it took to grow them, and some bulbs were rarer and thus more valuable than others. Everyone believed that the price of Tulip bulbs would only go up, which led to people buying them on credit with the hope of selling them later at a higher price to repay their debt. However, when Tulip bulbs started dropping, people panicked and sold them at any price. This resulted in many people going bankrupt.

Mental Accounting

Mental accounting is the inclination of people to interpret and remember information in a way that confirms their preexisting beliefs while ignoring contradictory evidence.

For example, an investor may hold onto a particular stock despite clear evidence that it is not performing well because they have a personal attachment to the company. Or they may be holding on to relevant information many years ago, but they have lost touch with the reality of the investment as it currently stands. They ignore the facts that don't align with their beliefs.

Risk Aversion Bias

This bias refers to people's tendency to choose options with known outcomes or lower perceived risk, even if riskier options offer higher expected returns.

One of the most common instances where we see this bias is when people decide to move everything to cash because of the fear of market downturns. They neglect the risk of inflation and the additional work needed to save their funds for retirement in exchange for less potential volatility.

Sometimes, people become hesitant to take risks after experiencing a negative outcome. For instance, they might have suffered a significant loss in their portfolio during a market slump. However, it is common for people to overlook the fact that they might currently be invested in a less risky asset allocation than they were during the previous downturn.

Hindsight Bias

People tend to perceive events as more predictable after they occur. For example, an investor may look back on their decision and feel it is evident in hindsight when it was not.

We all have experienced conversations with our significant other where they say, "I knew you were going to say that." The truth is that it's easy to know enough about someone that we're not surprised by their actions in certain situations.

However, hindsight bias can make us overconfident in our judgments based on the available facts. The problem with this is that we oversimplify what is going on. This can be dangerous when we use this overconfidence in predicting the outcome of an investment. We may fall prey to hindsight bias and make inaccurate predictions if we perceive patterns that may not be there.

The Gambler's Fallacy

This bias is the belief that future random events are influenced by past events in a way that balances previous outcomes, even when there is no logical reason for such an influence.

For example, a person may believe that a coin is more likely to land on heads if it has landed on tails several times in a row when each coin flip is independent of the previous one.

Investors can easily fall into the trap of relying on past performance when making investment decisions. They may consider an investment's previous winning or losing streak to indicate its future performance.

For instance, they may purchase an investment that has been performing poorly for the last few market cycles, hoping it will rebound and become profitable again; however, when they overlook other factors that could impact the investment's value, such as changes in the market or the company's financial health. In that case, they may be setting themselves up for failure.

The Winner's Curse

The Winner's curse is when an investor pays more for an investment than it is worth. This usually happens due to a lack of awareness of the investment's intrinsic value, and the investor ends up outbidding others.

For instance, an investor might get carried away in a bidding war for a property and pay much more than the property's actual value. This situation often arises when all the bidders assume that their fellow bidders understand the value of the item or property they are bidding for. In reality, each bidder may be increasing their bid because of the influence of the other bidders.

Understanding Behavioral Biases

By understanding these biases and tendencies, investors can become more aware of their decision-making processes and make more rational financial decisions. It's difficult to overcome these biases, but knowing them is an essential first step.

Conclusion

In conclusion, behavioral finance is an important field that can help investors better understand their decision-making processes and make more rational financial decisions. By recognizing the various biases and tendencies affecting financial decision-making, investors can become more informed and make better decisions in the long run.

To learn more about behavioral biases by talking to one of our financial advisors in Salt Lake City, Utah. Or join one of our financial wellness webinars.