What Is Behavioral Finance?

One of the terms that tends to pop up more and more when people talk about money and economics is “behavioral finance.”

Behavioral finances is a relatively new field of study. The idea is to look at the reasons that people make the money choices they do (those choices are often irrational). Behavioral finance applies psychological theories, particular those related to cognition and behaviorism, to economics and personal finance.

Behavioral finance is all about trying to understand biases in human behavior when it comes to money. By extension, the personal decisions that people make about money can be extended to influence the economy. With more and more individuals participating in the economy through consumerism as well as investing, it is little surprise that what makes humans “tick” when it comes to money is of prime interest.

Key Concepts in Behavioral Finance

It helps to understand some of the key concepts in behavioral finance if you want to grasp what this study is all about. Here are some of the main ideas that stem from behavioral finance:

• Mental Accounting – This is the tendency of people to designate money for a certain purpose. For instance, they divide up money and treat it differently, depending what “account” it's in. So, money in a savings jar is treated differently than money meant for debt repayment. People tend to say that money in that savings jar can't be used for another purpose, even if it means paying down debt at 15% interest.
• Herd Behavior – Following the crowd is something quite common, and it results in some of the most interesting effects. As the larger group does something — like buy a “hot” stock, or sell in a panic when the market drops — individuals tend to follow suit. Breaking herd mentality is one of the best things you can do for your own finances.
• Anchoring – This is the idea that you attach your spending level to a specific reference. You might think that a “good” bottle of wine should cost a certain amount of money. You might see the most expensive wine on a restaurant's list costs $100 a bottle. Normally, you would only spend $25 on a bottle of wine. But since you are now anchored to the idea of “the best” costing $100, you don't want to spend “only” $25. Instead, you “compromise” on a $45 bottle of wine. You spent more than you wanted, because of that anchor. The same thing happens with clothes, shoes, homes, and a number of other purchases.
• Belief in Being “Above Average” – Most people rate their intelligence as “above average.” At least that's what my Psychology Ph.D. husband tells me. He also points out that most people see success as something that they caused. Setbacks, though, are blamed on external forces. So, an investor might believe that he or she is a stock picking genius when an investment performs well. However, when that investment tanks, that same person, rather than believing that he or she is below average at stock picking, blames the drop on “the market” or “the economy.”

There are other concepts in behavioral finance that help explain irrational human behavior. You can overcome some of these biases, though, by being aware of them, and adjusting your own behavior to reflect more practical and rational behaviors.