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Understanding Behavioral Finance

November 2008

Barbara O’Neill, Ph.D., CFP®
Extension Specialist in Financial Resource Management
Rutgers NJAES Cooperative Extension

Do you want to become wealthy? One way is to avoid common behavioral finance errors that hinder wealth-building progress. 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. In other words, it helps to explain what “makes people tick” financially. Traditional economics is based on the assumption that people behave rationally but, in real life, many times we do not.

Below is a description of three common behavioral finance errors and how to avoid them:

Mental Accounting – Mental accounting is the term given to situations where people separate their money mentally into different “accounts” and treat the accounts differently. A dollar in one location is valued differently 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.

You can put mental accounting on your side by using this tendency to earmark money for future financial goals. For example, setting aside 5% of your salary in an employer 401(k) or 403(b) plan and leaving it alone to accumulate tax-deferred for retirement. Another example of mental accounting is setting a personal policy to save or invest at least half of all “windfalls” such as tax refunds and cash gifts or prizes.

Anchoring – This behavioral finance error 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. When purchasing a product or service, follow “the Rule of Three” and compare the cost and features of at least three competing vendors.

Overconfidence – Overconfident investors over-estimate their abilities or knowledge with respect to personal finance. They 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 company’s 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.

You can avoid making overconfidence errors by diversifying your investments and following the recommendation of financial experts to avoid investing more than 10% of your portfolio in the stock of any one company.

Behavioral financial experts 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 book Why Smart People Make Big Money Mistakes by Gary Belsky and Thomas Gilovich.