What is Behavioral Finance?

As with any other human endeavor, the world of finance and economics is not exempt from the effects of human error and bias. Psychology, and psychological discomfort, can and does influence most decisions an individual will make throughout their lifetime – and this includes how they use their money.

Part social science, part economic theory, behavioral finance is an important concept for businesses as well as private individuals to grasp. Doing so may provide significant insight into the monetary decisions we make, and how we make them better.

Let’s dive in.

Understanding behavioral finance

“Behavioral finance” as a concept refers to the ways in which personal and group psychological phenomena influence what we do with our money.

Behavioral finance theory is most often applied to individuals working as finance professionals, including investors, brokers, and others, to explain “anomalous” happenings in economic contexts. 

It is used on a grand scale to mitigate instances of unpredictability in global markets, but it can also prove useful to individuals who may be trying to get a better handle on their personal relationship to finance.

In an ideal world, financial decisions would be made solely based on probability and projection. However getting to this point takes practice, and an acute awareness of our own behaviors and biases, and until we have cultivated proficiency in both these skills, we may continue to make imperfect (or irrational) financial decisions. This is the incident which “behavioral finance,” in a nutshell, describes.

Key concepts in behavioral finance

The broader phenomenon of behavioral finance is often broken down into 5 primary concepts which influence how, where and when individuals spend money. 

• Mental accounting describes the tendency to reserve specific sums of money for specific purposes, which prevents us from having a more holistic view of our finances, fragmenting the total of our wealth and diminishing its potential.
  
  For example, we might allocate a portion of our monthly income for “luxury” expenses, like eating out once a week, which may prevent us from fully considering how these purchases may be affecting our finances overall.
  
  
• Herd behavior is the easiest concept in behavioral finance to grasp: it means going with the crowd when it comes to where you’re choosing to put your money.
  
  Herd behavior can cause individuals to go against their better judgment and make purchases, investments or withdrawals they might not otherwise feel comfortable making simply because it’s what the majority are doing.
  
  If a high enough number of people are engaging in the same behavior, we may think it’s the “right” thing to do and convince ourselves that we need to make the same decisions, whether or not it is the correct one for our own financial situation.
  
  
• The emotional gap can influence our financial decisions when we are impacted by an extreme emotion, whether that’s fear, anxiety, excitement, anger, etc. 
  
  For example we may sell stock too early out of fear that the investment will fail to grow or fail completely. Or, we may decide to buy a new car with money we don’t have because we are excited about the latest features offered in our favorite vehicle model. We might also over-buy predatory insurance packages because we are anxious about our health.
  
  All of these are examples of how the emotional gap can affect financial decision-making.
  
  
• Anchoring happens when we refuse to or are unable to change our perception of the value of an item, service, stock, etc. even as it is changing. If we are introduced to a thing with one value assignment, we may become attached to that value and fail to internalize that that value is no longer the same, especially, when that value has lessened.
  
  For example, we may have purchased a piece of furniture at a certain price point. Through a period of use, the value of that piece of furniture has lessened significantly. If we are anchoring, however, we may still attempt to sell the piece for the same or a similar amount for which it was initially purchased.
  
  
• Self-attribution is quite simply over-confidence in our own skills, knowledge, or understanding of a financial concept or situation. In these instances we may ignore the advice of professional consultants, friends who know better than us, market experts, etc. because we believe we know better than others (or indeed, than we actually do.)
  
  This can lead to unwise spending, investing, and withdrawing decisions if we fail to listen to the advice of those around us – who may actually know better than we do.

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Taking advantage of behavioral finance theory

Cultivating awareness of these tendencies within ourselves can allow us to address our own biases and irrational financial behaviors and make better spending, saving and investing decisions that allow us to make and do the most with our money.

Getting a firm grasp, first, of the behavioral finance concepts above will allow individuals to begin noticing their own behavior and how these concepts show up therein. Once we have this understanding, we can start to make concerted efforts to change.

Origin’s role in addressing behavioral finances

Addressing our own financial psychology sounds like a monumental task, but Origin makes it easy.

Offering a holistic view on personal finances, including total income, investments, debts, savings, and more, Origin empowers grounded, rational decision making when it comes to what to do with your money.

With practical tools including an at-a-glance dashboard, access to expert financial counselors, and comprehensive financial education, users can avoid the detrimental effects of behavioral finance and cultivate a better financial future for themselves and their families.

Wanna know more about what Origin has to offer? Sign up for a free demo today.