Behavioral finance combines two disciplines--psychology and economics--to explain why and how people make seemingly emotional or illogical decisions with respect to spending and saving money. Traditional economics is based on the assumption that people behave rationally. In real life, however, many times we do not.
Below is a description of three common behavioral finance errors:
Mental Accounting--This is where people separate their money mentally into different "accounts." A dollar in one location is valued as more or less important than a dollar in another. Mental accounting can be a good thing when it helps people focus on their future financial goals, like saving for a car or retirement. It can also be a cause of problems when "the big picture" of one's finances is ignored. An example of a mental accounting error is carrying a 17% credit card balance when money to repay this debt sits in a 2% bank account. Another is "blowing" a large sum, like an inheritance or tax refund, while earnings from a paycheck are more likely to be saved.
Anchoring--This is a mental shortcut and can be defined as a "clinging to a fact or figure that should have no bearing on your decision." The problem with anchoring is that people then discount new information that does not fit their pre-conceived opinions (e.g., "the stock market is risky"). Anchoring is particularly dangerous when people know little about the product or service being purchased and ignore valuable clues. The best ways to avoid anchoring mistakes are to comparison shop before spending or investing money and to talk to others before making a large financial decision.
Overconfidence--This is an over estimation of one's abilities or knowledge. Investors often place too much emphasis on what they know, or think they know, based on personal experience. Two common examples are:
Confusing familiarity about a company or a product as a consumer with knowledge; and
Placing a high percentage of retirement plan assets in employer stock because you work there and think you know all about the company.
Behavioral financial experts like to caution that "money is money," no matter where it is kept and where it comes from. In addition, it is important not to substitute personal experience for investment research or mistake a bull market for superior stock picking ability. Additional information about behavioral finance topics can be found in the 1999 book Why Smart People Make Big Money Mistakes, by Belsky and Gilovich.