How to Use Behavioral Finance to Improve Your Money Habits

January 17, 2023

Let’s be honest – money is complicated. It’s not just about numbers in a spreadsheet. Our brains play a huge role in how we handle it. We've all been there – impulse buying a gadget we don’t need, or letting a small splurge turn into a significant overspend. The truth is, our financial decisions are often driven by psychology, not pure rational thought. That's where behavioral finance comes in.

What is Behavioral Finance?

Behavioral finance is a field that studies how psychological factors influence people’s financial decisions. It acknowledges that we’re not perfectly rational economic actors. Instead, we’re susceptible to a whole host of biases and heuristics (mental shortcuts) that can lead us astray. It’s essentially taking economics and applying a lens to understand why people actually behave the way they do with money.

Common Biases and How to Combat Them:

Let’s dive into some of the most common biases and, more importantly, what you can do about them:

Loss Aversion: This is arguably the biggest one. We feel the pain of a loss much more strongly than the pleasure of an equivalent gain. This is why we hold onto losing investments for too long, hoping they’ll recover.
- What to do: Reframe losses as opportunities to learn and re-evaluate your strategy. Focus on the potential future gains, not just the potential for a loss.
Confirmation Bias: We tend to seek out information that confirms our existing beliefs, even if those beliefs are flawed. If you believe you’re a good investor, you’ll likely only focus on successful investments.
- What to do: Actively seek out dissenting opinions. Do your research from multiple sources and be open to the possibility that you might be wrong.
The Endowment Effect: We tend to value things we own, simply because we own them. This can lead to overpaying for assets or holding onto things we no longer need.
- What to do: Before making a purchase, consider the opportunity cost – what else could you do with that money? Try to evaluate the item objectively, as if you were a stranger.
Anchoring Bias: We rely too heavily on the first piece of information we receive (the “anchor”) when making decisions. For example, if you see a shirt marked $50 and then it’s marked down to$ 30, you might think it’s a great deal, even if $30 is still more than you'd normally spend.
- What to do: Be aware of initial prices and benchmarks. Don’t let the anchor influence your perception of value.
Mental Accounting: We tend to treat money differently depending on where it comes from and where it goes. “Windfall” money (like a tax refund) is often spent impulsively, while savings are treated more carefully.
- What to do: Treat all your money as a single pool. Don’t compartmentalize your finances.

Taking Control – Small Changes, Big Impact

Understanding behavioral finance isn’t about becoming a perfect financial strategist. It’s about recognizing your own tendencies and making conscious choices. Start small – track your spending, set realistic goals, and challenge your assumptions. By acknowledging the biases that influence your decisions, you can take control of your money habits and move closer to your financial goals.