Behavioral finance is a field of study that looks at the psychological reasons behind how people use money. It is estimated that people make between 3,000 and 30,000 decisions per day. In order to cope, we use subconscious mental shortcuts or guidelines called heuristics.
A common heuristic is forgetting that "sunk costs" (e.g., a previously purchased concert ticket) are "sunk" (i.e., paid for regardless of whether you go or not). Instead, people make present decisions to justify past ones (e.g., driving in a blizzard to get to the concert). Below is a description of other common behavioral finance errors:
Mental accounting is the tendency to treat some sources of money different than others and is a double-edged sword. It can be a valuable trait, such as establishing a "no touch" college or retirement savings account, but the flip side is making illogical financial decisions such as earning 2% on money in a passbook account instead of using the money to repay an 18% credit card. Another mental accounting error is driving miles to a grocery store to save a few bucks without considering the cost of gas to get there.
Another aspect of behavioral finance is choice conflict. Research indicates that people make purchases more frequently when they have fewer choices because choices are a cause of great anxiety. "Decision overload" often results in inaction.
A common behavioral finance error is overconfidence, which is an overestimation of one's skills, abilities, and knowledge. Research indicates that people put too much stock in what they know. For example, if you work for an employer or buy a certain company's products, you automatically assume you know enough about it to make an informed investment decision.
Status quo bias is the tendency for people to "stand pat" and not want to make a change. Making changes causes discomfort and fear. An example that combines both mental accounting and status quo bias is not selling stock because it was inherited from your grandmother. There is both a fear of making a change (selling) and a separate mental accounting system for valuing inherited money versus other assets.
Number numbness is the fact that people don't understand probabilities. An example is purchasing insurance with low deductibles because people overestimate the likelihood of a claim. There are always winning streaks in investing due to randomness but a low probability of consistently beating the market. For this reason, many experts advise investing in broadly diversified index funds to assure investment performance that mirrors market trends.
Loss aversion is another behavioral finance trait. Research with hypothetical examples indicates that people respond differently (about 2.1 times more intensity) to guaranteed losses than to guaranteed gains. Investors don't want to realize a loss unless they absolutely have to and will make decisions- or not decide- to avoid regret.
Anchoring is latching onto random numbers irrationally when making estimates. An example is comparing a sale price to a listed manufacturer's suggested retail price and thinking that the sale price is a good deal. Marketers are well attuned to this error and often use it to their advantage. Another common error is herding or simply changing behavior to follow what others are doing. Herding is commonly seen in stock market investing in both bull and bear markets.