CWA Blog Article - October 2023

Exploring Behavioral Finance: Mind Tricks & Money Decisions

Behavioral finance is like a window into our minds, revealing how our thoughts and feelings influence the decisions we make about money. Here, we're delving into four key concepts: overconfidence, confirmation bias, herding, and mental accounting, which shape how investors and the market behave.

Overconfidence

Overconfidence implies an inflated belief in one’s abilities or knowledge. An overconfident investor, convinced they can consistently beat the market, may make excessive trades, risking significant losses. Remember the 2000 dot-com bubble? Overconfidence in the burgeoning internet sector led to disastrous financial outcomes when the bubble burst.

Confirmation Bias

Confirmation bias is a mental shortcut where we pay attention only to information that agrees with our beliefs. An investor might only seek positive news about a stock they’ve purchased, ignoring warning signs, leading to ill-informed decisions. This bias played a role in the 2008 housing bubble when ongoing rises in housing prices were favored, while clear signs of overvaluation were ignored.

Herding

Herding entails following the crowd, often leading to unsustainable trends in market prices. Think of the cryptocurrency market, where tales of extraordinary returns for a particular form of crypto lure a flock of investors, ballooning prices to unsustainable levels. When these bubbles burst, followers of the herd can experience significant financial pain.

Mental Accounting

Mental accounting involves mentally dividing our money into different ‘buckets’, like ‘vacation’ or ‘bills’, and treating each bucket distinctly. This can lead to illogical financial decisions, such as refusing to use vacation funds to pay off debt, even if it’s the smart thing to do.

John’s Story: A Behavioral Finance Tale

Imagine John, who prides himself on his stock-picking ability due to past successes, showcasing overconfidence. Investing in a booming tech stock, he only pays heed to positive forecasts (confirmation bias in action). As others join in and the price skyrockets (herding), John, deeming this his “retirement fund” (mental accounting), refuses to sell. When the price plummets, John, stuck in his biases, hangs on, hopeful for a rebound, and ultimately faces significant losses.

Understanding these psychological triggers helps unravel the mystery behind financial decision-making. Recognizing that overconfidence can lead to risky choices, confirmation bias blinds to contrasting information, herding often results in asset bubbles, and mental accounting influences spending and saving, we can navigate through our financial journeys with more awareness and logical robustness.

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Any opinions are those of Allison Wilson and not necessarily those of Raymond James. Certified Financial Planner Board of Standards Inc. owns the certification mark CFP® in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.