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Imagine you find $100 on the street. Would you spend it on an expensive meal? Or would you invest it? 

The answer lies with behavioral finance, which examines how our brain affects how we manage and invest money. 

It may not come as a surprise, but most people would be likely to spend that windfall, even if they’re more prudent with their salary. That’s to say, they’d likely spend the $100 instead of investing it. Why is that?  

What is behavioral bias in finance?

Behavioral finance is a field of study that focuses on psychological factors that influence investors’ decisions in financial markets based on how they interpret and act on specific information.

Behavioral finance researchers have discovered that there are many mental shortcuts we use when we’re making complex decisions. And these heuristics can bias our judgments and lead to making missteps with our money. Behavioral biases are unconscious beliefs that influence our decisions. And they can affect your money, too.

Here are five common cognitive biases that can affect your relationship with money — and what you can do to overcome them.

1. Mental accounting

What it is: Mental accounting refers to the concept where people treat money differently depending on where it came from and what we think it should be used for.  

The idea is that we separate our money into “mental accounts” for different uses, which influences our spending decisions. We guard some money cautiously when we mentally categorize it for a house, but spend it liberally when it’s “fun money”.

That’s why most people are more inclined to spend windfall gains on luxury items but would save that same money if they’d earned it. Earned money has been mentally allocated to an account, but the $100 you find on the street hasn’t been.

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Why it’s a problem: Mental accounting can sometimes hurt your bottom line. For example, someone might choose to keep money in their college fund instead of paying off credit card debt. The money is already “accounted” for, which means they’d get stuck paying high interest on their credit card bills for carrying a balance each month.

If they’d chosen to pay off their credit cards instead, they could use the money that would have otherwise gone to interest to instead rebuild their child’s college fund — or even use it to invest and build long-term wealth.

How to overcome it: Create a budget to guide your financial decisions and better determine when to save versus spend money. And create a plan for how to spend windfall gains, like an inheritance or work bonus, ahead of time.

2. Loss aversion

What it is: Loss aversion is a bias toward avoiding losses over seeking gains. For example, a 2019 study in Scientific Reports found people are more sensitive to losses than they are to comparable gains when making decisions.

Robert R. Johnson, professor of finance at Creighton University’s Heider College of Business argues that loss aversion can cost us money. “The biggest financial mistake people make is …read more

Source:: Business Insider

      

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