As humans, it’s natural to take mental shortcuts when faced with difficulty. But, when it comes to finances, we may be over-complicating our approach because of our own behavioral biases. Let’s break down what behavioral biases are, and how you can stop them from draining your bank account.   

Understanding Biases in Behavioral Finance 

What is a behavioral bias? 

A behavioral bias is an irrational behavior or belief that interferes with your decision-making process. Behavioral biases result from your brain’s inability to give “due process” to all the information you come across.  

Emotions, subjectivity, and incomplete information influence your understanding of any situation. So how can that affect your account balance? Let’s find out. 

How do behavioral biases affect financial decisions? 

Biases affect every aspect of your life, from love and relationships to movie reviews. But the effect of bias in economics is so complex and fascinating that it has its own field of study—behavioral finance.  

Money is just a symbol of value. And as humans, we are tasked with reconciling the subjective value of things (i.e., goods and services) with their objective value (as defined by the market). But unfortunately, we aren’t always capable of accurately making those determinations.  

The effect is that we make illogical or ill-informed decisions, which often result in losing money. Behavioral finance explores the things that influence our financial decisions—and bias drives many of those decisions. 

Let’s explore some of these biases and learn how to overcome them. 

7 Common Behavioral Biases in Personal Finance   

Fortunately, knowing about behavioral biases is often enough to help you avoid them. As you learn more about each bias, you’ll probably remember a time when you made an irrational financial choice. And in the future, you’ll be a little more methodical.  

1. Confirmation Bias 

Confirmation bias refers to our tendency to favor information that “confirms” our beliefs. For example, if you believe that the world is inherently dangerous, you may hear a story about a crime that occurred in an up-and-coming neighborhood in your city and decide not to purchase a home in that area.  

A news item the very next day about lowered crime rates and increased police presence still wouldn’t be enough to change your mind about buying that house.  

Although rising property values would make that home a wise investment, you overvalued the information about the criminal incident, and you undervalued the information about overall crime rates—all because the first news story confirmed your previously held notion that the world is dangerous. 

How to Avoid It 

  • Actively seek out information that contradicts your opinions, especially if it makes you uncomfortable.  
  • Diversify the sources of information that you rely on.  
  • Pay attention to all the times that you’re proven wrong.  

2. Loss Aversion 

Have you ever noticed that the pain of losing money is much greater than the joy of making it? In behavioral finance, loss aversion refers to the fact that humans really hate losing things. Loss aversion can negatively affect you financially if you choose not to take risks with a potentially high payoff. 

How to Avoid It 

  • Don’t get too emotionally attached to your financial decisions.  
  • Remember that money comes and goes. Focus more on the opportunity to make money than the risk of losing it.  

3. Recency Bias

Recency bias refers to your tendency to overvalue recent events. For example, a recent dip in a particular stock’s value might dissuade you from buying shares, even if that dip is just a fluctuation in an upward trajectory.  

How to Avoid It 

  • Make sure you’re “zoomed out” enough to get the complete picture of a particular trend.  
  • Avoid making reactionary investment decisions.  
  • Weigh the pros and cons of a financial choice based on your long-term goals 

4. Familiarity Bias 

Would you be more inclined to buy a detergent that you’ve been using for years, even if more economical options are available? You may have fallen victim to familiarity bias. In finance, this bias dictates that people prefer investments that feel familiar to them. You might think your familiarity makes a financial decision feel like a “safe bet,” but that’s a flawed assumption.  

How to Avoid It 

  • Recognize when you default to a choice that feels familiar. Have you weighed the other options? 
  • Do a little research on any other available options before making a decision.  
  • Analyze each of your investment options on an individual basis.  

5. Overconfidence

Do you think you’re a good driver? Most people would probably say yes, even though, by definition, the vast majority fall somewhere on the spectrum of average. People tend to be overconfident, which can be a problem in finance. In finance, overconfidence often causes investors to overestimate their ability to predict stock market upticks. 

How to Avoid It  

  • Seek out the advice of leading experts before making any rash decisions.  
  • Always play devil’s advocate with yourself. 
  • Consider the consequences of being wrong.  

6. Scarcity Heuristic 

Just because something is rare doesn’t necessarily mean it’s valuable. The scarcity heuristic is the belief that rare things are inherently valuable. And while that’s true in some cases, not every rare asset is a diamond. 

How to Avoid It 

  • Buy assets that are valuable to you rather than buying them because they’re rare. 
  • Don’t be fooled by marketing that preys on the scarcity heuristic (i.e., “limited edition” merchandise). It’s not necessarily a good investment.  

7. Gambler’s Fallacy 

If you lose eight hands of poker, you’re bound to win one of the next ones, right? Wrong. The gambler’s fallacy is one of the biggest mistakes you can make when investing.  

How to Avoid It 

  • Base your predictions on the evidence available. 
  • Don’t assume any particular outcome is likely to happen just because you feel it’s “due.” 

Final Thoughts 

No one is immune to behavioral biases. Part of being human is looking for patterns where there are none. In the world of money and beyond, we’re vulnerable to miscalculations and misapplied heuristics. But understanding how our thought processes can fail us is often enough to help us make better judgment calls in the future.  

Need more support? Julep pairs psychology with financial management techniques to help you change your money mindset.

Post Disclaimer

Julep is not a financial institution, financial advisor, or credit repair company, and does not provide credit repair services of any kind. The information provided is for general educational and reference purposes only. The information is not intended to provide legal, tax, or financial advice. We do not propose any guarantee that the information provided will repair or improve your financial profile. Consult the services of a competent licensed professional when You need financial assistance.

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