How to Use Behavioral Finance to Improve Money Decisions

June 10, 2023

Let’s be honest – most of us aren't exactly known for our rock-solid financial decision-making. We’ve all been there – that impulse buy, the subscription we forgot about, or the feeling that “it’s on sale!” But why do we make these choices? The answer lies in a fascinating field called behavioral finance.

What is Behavioral Finance?

Traditional economics assumes people are rational actors, constantly striving to maximize their utility. However, research in behavioral finance shows that human decision-making is far more complex. It acknowledges that our emotions, biases, and cognitive shortcuts significantly impact our financial behavior. It’s not about being “bad with money”; it’s about understanding how our brains are wired and using that knowledge to our advantage.

Key Concepts & How They Affect You

Let’s look at some common biases and how to counteract them:

Loss Aversion: This is perhaps the most well-known bias. The pain of losing money feels significantly stronger than the pleasure of gaining the same amount. How it affects you: You might hold onto losing investments for too long, hoping they’ll bounce back, instead of cutting your losses. What to do: Accept that losses are a normal part of investing and have a pre-determined exit strategy.
Framing Effect: How information is presented dramatically impacts our choices. For example, a product described as “90% fat-free” sounds much more appealing than one described as “10% fat.” How it affects you: Marketing techniques constantly exploit this bias. What to do: Be aware of how information is framed and seek out unbiased sources.
Anchoring Bias: We tend to rely heavily on the first piece of information we receive, even if it’s irrelevant. How it affects you: When negotiating a price, the initial offer often sets the anchor, even if it’s unreasonably high. What to do: Do your research and establish your own target price before entering negotiations.
Confirmation Bias: We tend to seek out and interpret information that confirms our existing beliefs, even if those beliefs are wrong. How it affects you: You might stick with an investment you believe in, even if the market indicators suggest otherwise. What to do: Actively seek out dissenting opinions and challenge your own assumptions.
Mental Accounting: We tend to treat money differently depending on where it comes from or where we’re spending it. How it affects you: You might be more willing to splurge on a fancy dinner than to put the same amount into savings. What to do: Treat all money as part of one overall budget, regardless of its source.

Taking Control – Practical Steps

Track Your Spending: Awareness is the first step. Knowing exactly where your money goes is crucial.
Automate Savings: Set up automatic transfers to a savings account – you won't be tempted to spend it.
Review Your Budget Regularly: Don’t just create a budget and forget about it. Make adjustments as needed.
Seek Professional Advice (Wisely): A financial advisor can help you navigate complex decisions and identify your biases.

The Bottom Line

Behavioral finance isn’t about blaming yourself for making “bad” choices. It’s about understanding the powerful forces that shape your financial decisions and taking proactive steps to build better habits. By recognizing and addressing your biases, you can take control of your money and achieve your financial goals.