This may surprise you, but humans are not always rational in how we make financial decisions! In the past, economists thought that humans only looked at financial issues from an entirely rational perspective. However, in more recent years, a new awareness evolved from the intersection of economics and psychology called Behavioral Economics. The influence of psychology on economics showed a side of human behavior that was often not rational.
The influence of psychology on economics showed a side of human behavior that was often not rational. Understanding how and when one’s biases can creep into financial decision-making may help you “self-correct” back to a more rational and effective plan.
Dr. Richard Thaler, a University of Chicago economist, won the 2017 Nobel Economics prize for his work in this area. He postulates that humans have two systems for processing information specifically as it pertains to economic decisions 1: The first type of decision maker is basing decisions upon reflective analysis (“conscious thought”), which Thaler gives the formal name of Econ (and the informal name of Mr. Spock). The second system is basing decisions upon automatic thought (“gut reaction”) and is called Human (or Homer Simpson). Several issues can arise with gut reactions, as they are based upon psychological biases and mental shortcuts that may lead to irrational decision making.
What follows are brief descriptions of common psychological biases people face during the financial decision-making process, and examples of how our Human and Econ selves may deal with them.
Anchoring: making a decision based upon a number you determine as your starting point.
Scenario: You buy a stock for $100 and a year later it has decreased to $80. During that same period, the stock market was doing well yet this stock continues to do poorly.
Human: Homer decides to wait until the stock retraces its decline and gets back to $100 before he sells, in order to avoid (or admit to) recognizing a loss.
Econ: Even though the stock is trading at a loss, Mr. Spock would analyze the relative future opportunity of the stock vs. other investments over a given time frame and makes the best investment decision available. If better investment opportunities exist elsewhere, Mr. Spock would realize the loss in the current investment for the prospect of better performance in the future.
Takeaway: Anchoring can prevent us from acknowledging sunk cost. Do not dwell on what has happened, but instead focus on what the best action is moving forward with the information you have available. Stocks do not have a memory…i.e. they do not know what their high or low price was!
Mental Accounting: segregating money for specific purposes.
Scenario: You just retired and need to decide how you will use your investment accounts to fund living expenses. A financial forecast shows that you can safely withdraw $100,000 per year (plus inflation adjustments) to meet your needs and have an adequate cushion should you live to age 100.
Human: Homer tries to design a portfolio that relies on dividends and interest from specific taxable accounts to provide income for spending needs; he does not want to touch principal because that would be “losing money”. His investment strategy focuses only on yield, which causes him to pair back his quality of life needs.
Econ: Mr. Spock uses dividends, interest, and principal from all of his taxable accounts. His investment strategy considers dividends, interest and capital gains—a total return approach. Mr. Spock’s continues to live his desired quality of life while his portfolio grows.
Takeaway: Mental accounting can lead to short-sighted financial management strategies that often limit total return potential. Money is fungible—it does not matter if it comes from interest, dividends or capital gains.
Herd Behavior: people tend to mimic the financial behaviors of the majority.
Scenario: You are at a cocktail party with the Smith family who rave about their several extended vacations throughout the year with their three children. You are confident the Smiths are much better off financially than you are.
Human: Homer decides to spend money like his circle of friends to “keep up with the Joneses (Smiths),” with little consideration for his own financial situation. He wants to be part of the gang.
Econ: Mr. Spock analyzes his own financial resources and creates a budget to assess what he should realistically spend. He decides that one or two small trips are within his resource and respectfully declines other invitations.
Takeaway: Every person’s financial situation is different. Imitating others when it comes to spending or investing, especially those with different goals or constraints, can lead you astray from your own financial objectives.
Loss Aversion: people dislike losses more than they like gains of the same amount.
Scenario: You have been asked to complete a Risk Tolerance Questionnaire as part of your new investment program. There is a question asking you how you feel about losing $1,000 compared to making $1,000. While you have been investing in the financial markets for many years you have never thought about this question before.
Human: Homer does not like losing money, so he responds that he dislikes losing $1,000 far more than he likes making $1,000. He would like an investment program taking this into account.
Econ: Mr. Spock dislikes a $1,000 loss to the same degree as he likes a $1,000 gain. His investment program will be neutral as to his preference for gains vs. losses.
Takeaway: Recognizing that you are exhibiting loss aversion in your thinking should enable you to pursue an investment program more suited to your needs and objective, rather than one constrained by your emotions.
Confirmation Bias: judging information in a way that confirms one’s pre-existing beliefs.
Scenario: You have been a Do It Yourself investor until now and feel fairly secure in your beliefs about the financial markets. Your new Advisor recommends that you invest in bonds as part of a diversified portfolio.
Human: Homer lost money in bonds several years ago and has been averse to owning them since then. He rejects his Advisor’s advice based upon that perspective and his 100% equity portfolio rises and falls with the overall stock market.
Econ: Mr. Spock considers the current and future market environments and how that will impact bond performance. He incorporates a more balanced approach that incorporates bonds and enjoys the benefits of less volatility and some yield.
Takeaway: It is often advisable to reconsider your preexisting beliefs as current economic conditions may be very different from past conditions when your beliefs were formed.
Understanding when behavioral biases appear in your financial decision making should lead to your inner Mr. Spock winning out more often over your inner Homer Simpson. More sound, disciplined decision-making in both investment and personal financial planning will result, creating a higher probability that you will accomplish your financial goals. Your Round Table Wealth Management Advisor is integral in helping you identify these biases and is here to guide you to better financial decisions. We will be your “Mr. Spock”!1 Nudge—Improving Decisions About Health, Wealth, and Happiness by Richard H. Thaler and Cass R. Sunstein; Penguin Books 2009