Understanding Behavioral Finance to Overcome Financial Bias

Learn about the 5 areas of Behavioral Finance and why you should work with an experienced certified financial planner to avoid mis-steps.

Kevin Zywna, Wealthway Financial Advisors: Money can be good, or money can be bad. It’s neither. It’s an animal. It’s how we use it that determines whether it’s good or bad. And I have a very unscientific theory that is only supported by my life and professional experience, and that is extreme wealth, and extreme poverty can cause similar dysfunctions. I think a lot of people think “Oh, come on, poverty is way worse.” Yes, there are certainly bad aspects to poverty. But when you think of really crushing poverty, situations where you can’t work your way out of. You become hopeless. You feel like you can’t get out of your circumstances. You start to give up. You start to take shortcuts because why bother working anyway? Why bother going to school? I will never amount to anything. I will never have enough money. I can’t find a car. The crushing aspects of poverty become debilitating. And guess what? Having a lot of money especially well, let me clarify on earned money. People earn their money, start a business, work really hard, sell it, get a lot of money. They’re pretty healthy. Work hard, become a professional athlete, make a lot of money. You understand the sacrifice and discipline it took to get there. People tend to have healthier approaches to money, a lot of money when they’ve earned. Unearned money, a lottery inheritance, some windfall like that. An unexpected windfall, mainly inheritance that the child of very wealthy people… think of how many children throughout history have struggled trying to find their way in life. Why? Because they can do anything. And when you can do anything, you can also do nothing. And you have no ambition, no drive. You don’t have to go to work. You don’t have to go to school. You don’t have to work hard. We all have to try. What’s there to live for? Some superficial boats, drugs, you know. Unearned money is crippling and debilitating and can cause some of the same dysfunctions that poverty does as well.

Behavioral Finance Versus Conventional Finance Theory

Kevin Zywna, Wealthway Financial Advisors:  Tonight we’re talking about behavioral finance and overcoming financial biases. How does behavioral finance differ from say, conventional financial theory? Well, conventional financial theory, as I was taught in college, and I think I’m pretty sure they still teach in college, is that we are all rational actors, maximizing our utility, dispassionately assessing, and weighing pros and cons of every financial decision purchases, debt investments. We are cold calculating ruthless machines, that we can build formulas around and equations and with that, we can sort of predict the future outcomes. Companies are rational actors purely built for profit maximization in very strict organizational fashion. Well, what I learned a while ago is not reality, that is theory. But it is not practice. And it is not real world. Institutions, companies, businesses are made up of people. And people are inherently fallible, and we are all subject to biases and gaps in knowledge and emotions that skew the rational thinking that conventional financial theory teaches.

What Is Behavioral Finance?

Conventional finance theory assumes that the markets are efficient, and firms are rational, profit maximizing organizations. But behavioral finance counters each of those assumptions. Behavioral finance theory introduces the human element into financial theory. By understanding how and when people deviate from rational expectations, behavioral finance provides a blueprint, kind of to help us make better, more rational decisions when it comes to financial matters. Because by studying our mistakes, we can learn about them. We can correct them. We can be smarter about them. We can get better about overcoming them, and we can be better decision makers.

What Are The 5 Areas Of Behavioral Finance?

What are some of those the areas of study of behavioral finance. There are five main topic areas: mental accounting, herd behavior, emotional gap, anchoring, and self attribution. And then each of these areas of study leads into more personal biases. And each of us are susceptible to these to different degrees. Some of us may be very susceptible to herd behavior following the group, while others of us might not be swayed by that at all – we don’t care what other people are doing, I’m going to do my own thing, man. But you know what, I might have a problem with self-attribution, which is where I think that I’m smarter than I am. And I have more control over outcomes than I actually do. And then that can cause me to make bad decisions. So let’s go through a few of these and take them a little bit more in detail.

Mental Accounting: Behavioral Finance Where You Earmark Funds For Specific Purposes First

So mental accounting, mental accounting refers to the propensity for people to allocate money first, for specific purposes. On the surface, that’s not necessarily a bad thing. It’s kind of like bucketing, right? Some people like to bucket their money. Do that with a Christmas club. Do they do Christmas clubs anymore? Well, when I was a kid, we had, I had a Christmas club, and put in like dollar away a week, and 50 weeks, you got 50 bucks to spend on Christmas. It was bucketed in the Christmas Club account and couldn’t be touched for anything else. So you’ve sort of mentally cordoned off that area of your finances. And so if you do that in small degrees, then that’s definitely not harmful and can actually be beneficial. But if you cling too tightly to the idea of segmenting your finances, segmenting your money into different buckets, then they can become counterproductive. For most of us, and in our practice, one of the primary goals is to grow your net worth over time, (net worth is another term for your wealth). All your assets minus your liabilities equal your stuff, your money, your net worth. And if you bucket too much, and you cling to those buckets, you tend to make independent decisions for each bucket, which might not be good for the overall whole. Because you don’t see the forest through the trees. That’s it, you’re focused on the minutia instead of the big picture. And that can be self-limiting to your net worth. So mental accounting, taking too far, can be counterproductive.

Herd Behavior: Behavioral Finance Where Financial Decisions Follow The Masses

Herd behavior states that people tend to mimic the financial behaviors of the majority of the herd. Herding is notorious in the stock market as the cause behind dramatic rallies and sell offs, right? When we have extreme highs and extreme lows people are just following the herd. They’re doing what their officemate is doing. They’re doing what their neighbor is doing. Well, if everyone else is doing it, I better be doing it too. Because they must be right. I’m not sure what I’m doing. So if everybody else does it, I’m just going to do what they’re doing, following the herd. And you can follow the herd right off the cliff, if you’re not careful. So, you know, herd mentality, probably good back in caveman days to keep us alive that so there’s some human element to where this stuff comes from that was very valuable for our survival. But when it comes to your own personal finances, heard behaviors, typically not a good approach. Your personal finances are unique and personal to you. Your goals are unique and personal to you. Therefore, the techniques that you use to try to achieve those goals and objectives are most likely different than the herd. So just doing what everybody else is doing because they’re doing it doesn’t necessarily lead to success. In fact, it usually leads to let’s call it I won’t call it failure. I’ll call it underperformance.

The Case For Understanding The Impact Of Behavioral Finance

I was talking about some of the main behavioral finance concepts and issues that result from the human element and our relationship with money. It is not as I was taught in college. I often wonder why I paid so much money for some of this financial education. Because mainstream financial theory makes the assumption that people are rational actors, that they are free from emotion, or the effects of culture and society relations and that people are just self-interested utility maximizers. And so, by extension, that the markets are efficient, and firms are rational profit maximizing machines. Behavioral finance throws a wrench into all of that by saying, not so fast. There are human beings that orchestrate all of this. There’s a human element to all of it. Humans are not yet perfect beings. We make mistakes. We have weaknesses, some of them as they relate to money. So, we study them. We talk about them. We try to learn from them. And we try to get better at our decision making when it comes to money. So, I was going through a list of some of the main behavioral finance concepts. I was getting to emotional gap.

Emotional Gap: Behavioral Finance Of Making Financial Decisions Based in Emotions

Emotional gap refers to decision making based on extreme emotions, or emotional strains such as anxiety, anger, fear, excitement. Oftentimes emotions are a key reason why people do not make rational choices. The more emotional you are in making a decision, typically speaking, the more wrong that decision is going to be. Emotions, of course, are important. They are what makes us human. Showing good healthy emotions to one another and our fellow man makes the world a better place. Emotions are not inherently bad. But too strong of emotions, or improperly placed emotions around finances and money, can lead to bad decision making.

Fear and greed are two of the biggest emotional drivers of finance, investing, and personal gain. It’s well documented in stock market performance, that those emotional swings between fear and greed are what sometimes drive the equity markets to unhealthy positions. Too high sometimes, more than valuations would suggest, and then too low sometimes. We’re just too high – greed, it’s going up. Have to get in. Have to stay in, have to follow the herd. Want to get in.

What was that app? Robin Hood.  Robin Hood was a stock trading app that was kind of popular with millennials a couple years ago. And it made it made buying stocks or mutual funds, ETFs, like a game. You bought some stocks, and some confetti gets released. And there’s some balloons, and you think, “this is fun.” And all my friends are doing it. There’s a theory that because it was so popular at the time, it was an unhealthy driver of stock market prices on the high end. The stock market prices during that period of time might have been more elevated than circumstances and cold rationality would suggest. So, you know, greed, going after more fun, let’s play the game. That’s not a bad thing.

But the opposite is true. Fear – stock market starts to decline. It’s into bear market territory – 20%, or greater decline from some previous peak, maybe goes down further. People who don’t have an investment plan, an investment strategy, and don’t integrate that investment plan with an ongoing analytical financial plan, they don’t know what this means. They don’t know what this decline really means. Do they have to work longer? Are they going to run out of money one day? Will they have enough to live on in retirement? I don’t know. But all I know is my account value keeps going down. And I don’t want to lose it all. I’m going to be wiped out. I have got to sell. I have to get out. I don’t care that I’m selling it at a loss. I don’t understand what’s happening here. I want out. I’m terrified. Make it stop?

Well, that’s the absolute wrong thing to do at that period of time. That’s one of the best times to be buying. But yet fear takes over. And so people sell – they lock in losses. That’s a permanent loss. And you don’t recoup that very easily. You’ve got to get back in at some point. And people who have been burned like that, typically either don’t get in quickly, and they miss a big run up, or they’re done. And they’re just done investing. They take the money to the bank, and they live on 1 or 2% of interest rates out of savings and checking accounts. Which really draws down your standard of living unnecessarily, all driven by extreme emotion and emotional gap.

Anchoring: Behavioral Finance Of Making Financial Decisions Based on Past Asset Values

So anchoring, attaching rigidly to a past value to the detriment of effective decision making. We see this one from time to time in our practice. Well, you know, my assets were over a million dollars. And I don’t want to do anything until it gets back there. I wish I had that million dollars that I saw a year ago on my statement. Well what would you have done differently? Well, nothing but I just I just want to see a million dollars. Well, you know, you still have $900,000 And we’ve done the math, we’ve done the analysis that’s still more than enough to live comfortably on for the rest of your life based on your current spending level. Yes, but I want a million dollars. But why do you want it? Because I had a million dollars once. So you’re anchoring to a number that doesn’t really have that much overall meaning, just because it was there at one point in time. And so you lose sight, you lose focus of what is really important. Which is, do I have enough money to last my lifetime at my current spending level. You lose focus of that. And then you fixate on this idea of just having a particular number in order to make you happy. And it’s not the number that makes you happy. They forget, it’s the fact that you have enough total assets combined to generate enough income to support the that you have become accustomed to. So just anchoring is sort of an irrational stance towards looking at your investments.

Self-Attribution: Behavioral Finance Of Decisions Made Based On Overconfidence In Your Financial Knowledge Or Skill

Self-attribution is the fifth sort of main behavioral finance concept. And this is one of my favorites. Self- attribution refers to a tendency to make choices based on overconfidence in one’s own knowledge or skill. Self-attribution usually stems from an intrinsic knack in a particular area. And within this category, individuals tend to rank their knowledge higher than others, even when it objectively falls short. So the little bit of technical jargon in there, but what that refers to in our world, and I’m going to have to apologize in advance for certain career occupations, but doctors tend to have an over inflated sense of their competence in finance, based on their excellent skill of saving human lives and, and making us healthier and better. It’s actually called the Dunning-Kruger effect, when somebody is really competent at one thing so then they think they must be great at other things, too, because I’m so great at this one thing, which may have no relevance to each other. So, doctors are kind of known. We have some doctor clients that are wonderful clients, and they’re an exception to all of this. I’m not talking about all doctors. But because they’re really good at a really important thing. Then that confidence, overconfidence, or the confidence there leads to overconfidence in other areas in which they don’t have as much competence.

So they tend to think that they are more competent than they actually are in managing money, because they’re really good at doing really important things, like saving lives and making us healthier, which is really important. And we’re not discounting that at all. But that doesn’t make them good financial stewards. Another one that I’m going to throw out there is engineers. Engineers think investing is a problem, is an equation, that can be solved. That if they just buy the right inputs, the right plus multiplied by sub square root of two, the exponent to the third power, then I’ll outperform everything’s an equation that has an answer. But that’s not true.

WNIS: It’s like when you say, you can’t predict stocks, you can’t predict stocks, but Kevin, I had that Robin Hood app, and it has all the graphs and different charts that show you the ups and downs. And if you just follow the formula, you get it right. That’s what the guy’s online say, Right?

Kevin Zywna, Wealthway Financial Advisors: Right. It doesn’t work that way. And I think some of the ego kicks in there too. Because if you’re really good at one thing and people around you acknowledge you’re really good at that thing. Well, it takes a lot to get there. It takes a lot of knowledge, it takes a lot of discipline to get ther, and it takes some ego. Sometimes it gets in the way of our good decision making, like you said with emotion. And while there is a fair amount of science in the investment management process, and math and equations and technical study, there’s also a fair amount of art involved as well. So it’s a little bit like architecture, as opposed to engineering. Architecture is foundationally built on engineering and science and you know, I guess weights and angles, yes. But also, the beauty. It’s how the architect uses the technical to create a beautiful structure, which is artistic, and maybe enduring and beautiful to look at. Using the technical part, to create something artistic, and in total, it’s a much better process.

Last one, I’ll slide in there a fair segment of the do it yourselfers don’t know what they don’t know. But they think they know everything they need to know. So they don’t really know as much as they think they do. But they think it’s enough. And hey, it’s your money, you can always do with your money, what you want to do. And if you’re content and happy doing it yourself, then you should just keep doing that. But in almost every case, a professional, competent fiduciary professional financial adviser can bring much more resources to your personal financial situation. And I would just say, we see a lot of underperformance in totality from do it yourselfers that they tend to fixate on the wrong thing. They don’t see the big picture. They don’t know what they don’t know. And then are content to do it themselves. And so they grow their net worth a lot slower than somebody who works with a professional because of self-attribution.

WNIS: So Kevin, you’ve laid out a lot of different examples of just the way that people think when it comes about their money. When it comes to thinking about and managing their money and some of the hangups that people have. So if that rings out to somebody listening right now, and they go Yes, yes, that kind of sounds like me, what is the first step to talking with a financial advisors? Again, if we don’t trust people, and we don’t want anybody else touching our money, and I don’t talk from experience, I don’t really trust people. So you know, we want to hold that stuff tight. It’s so hard to work for it. I’m not ready to just lose it like people say, where do you start that search?

Kevin Zywna, Wealthway Financial Advisors: If you want to work with a financial advisor we always recommend you start your search with a certified financial planner, because it’s the highest mark of competency in the profession. And you can search for a CERTIFIED FINANCIAL PLANNER professional in your area, whether it’s here in Hampton Roads or Northern Virginia or down in North Carolina, if you’re listening down there. At the CFP boards website, they have a search feature. Their certified financial planner board of standards website, and I think their consumer facing website is called www.letsmakeaplan.org. So that’s a good place to start, right there. You plug in your city and searching and 25 mile radius search for certified financial planners next. Then you want to look for those certified financial planners that I believe worked for an independent registered investment advisor. So that would weed out some of the big boys. I guess I will not say their names, but the large institutional, industrial, financial brokerage houses, those are sales based financial advisors. In the red in the independent registered investment advisor space, that’s where we have more service based financial advisors, and that will point you in the right direction as well.

Behavioral Finance Wrap-Up

Tonight we’re talking about behavioral finance and the biases that can result. I went through a list of main topic areas from behavioral finance. Some biases that flow from those concepts that I want to get to pretty quickly before we run out of time here. Confirmation bias, when investors have a bias towards accepting information that confirms their already held belief in investment. So, you don’t look at it objectively. You don’t look at it, factually. You don’t look at it dispassionately. You just look for confirmation of what you already think about the investment. Experiential bias occurs when an investor’s memory of recent events leads them to believe that the event is far more likely to occur again, also called recency bias. So good example, that financial crisis 2008-2009, that was a doozy – that was a knee-knocker. That was a big decline in investment values. And a lot of people lost their jobs during that time. Recession, panic, chaos all around the place. People still remember that 15 years later, and they make decisions based on it. Loss Aversion occurs when investors place a greater weight on the concern for losses than the pleasure from the market gains. They are far more likely to try to assign a higher priority to avoiding loss than making investment gains. That emotion is where insurance companies make a ton of money selling equity indexed annuities. And then I’m going to have to hold familiarity bias for another time because I’m running out of time.

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