Basics of Behavioral Economics

The field of behavioral finance blends economics and psychology and acknowledges that people are often irrational decision makers. Everyone has cognitive biases, which are flaws or errors in thinking that can lead to poor financial decisions. The first step to mitigating errors is to become aware of common biases to plan to proactively minimize them.

Below is a brief description and examples of twelve common behavioral finance biases:

 

Action Bias- When people prefer to do something- anything- versus doing nothing in situations where an action or decision is required. It is similar to someone being tossed a hot potato and wanting to quickly toss it on to someone else.

 

Anchoring Effect- When people cling to a fact or figure and thereby discount new information that does not fit their pre-conceived opinions (e.g., “the stock market is risky”). Anchoring is particularly dangerous when people know little about a product or service and ignore valuable purchasing clues. Example: comparing a sale price to a suggested retail price and thinking that the sale price must be a good deal. Marketers are well attuned to this error and often use it to their advantage. 

 

Attentional Bias- When people prefer to focus on some things and not others as a way to cope with an overload of information and other stimuli. As a result, they have “blind spots” and often overlook possible options and outcomes.

 

Bandwagon Effect- When people support an idea simply because it has become popular, regardless of their own beliefs or comfort level. The 2021 “meme stock” frenzy is a recent example of investors “following the crowd.”

 

Confirmation Bias- When people have beliefs and “decision rules” in their minds and search for, and pay attention to, information that confirms them. Like attentional bias, this error can result in “blind spots” as people ignore information that is inconsistent with their beliefs and, as a result, often believe even more strongly in their original position.

 

Framing Effect- When people draw different conclusions about available options depending on how that information is presented rather than simply facts of the situation. They may make different decisions (e.g., saving money for retirement) depending on how information is presented to them.

 

Loss Aversion- When people try to avoid losses and make decisions- or decide not to decide- to avoid regret. Research with hypothetical examples indicates that people respond differently (with about 2.1 times more intensity) to guaranteed losses than to guaranteed gains. Investors don’t want to realize a loss unless they absolutely have to.

 

Mental Accounting- When people separate their money mentally into different “accounts.” A dollar in one location is valued as more or less important than a dollar in another and, as a result, “the big picture” of one’s finances is ignored.  An example is carrying an 18% credit card balance when money available to repay this debt sits in a 1% bank account. 

 

Overconfidence Bias- When people over-estimate their abilities and knowledge and place too much emphasis on what they know, or think they know, based on personal experience. An example is confusing familiarity about a company or product, as a consumer or company employee, with investment knowledge.

 

Recency Bias- When people use recent information to make decisions that are biased towards the latest news. For example, after hearing about a string of burglaries on television, they might be extra cautious about locking their doors at night. Similarly, investment decisions may be biased based on how the stock market is currently performing.

 

Status Quo Bias-When people “stand pat” and do not want to make a change.  Making changes causes discomfort and fear and people try to avoid this.  An example that combines both mental accounting and status quo bias is not selling stock simply because it was inherited from your grandmother.

 

Sunk Costs Bias- When people forget that “sunk costs” (e.g., a previously purchased concert ticket) are “sunk” (i.e., already paid for) and make poor present decisions to justify past ones (e.g., driving in a blizzard to get to the concert).

 

In summary, traditional economics is based on assumptions that people behave rationally. In real life, however, many times they do not. Strategies to reduce behavioral finance errors include comparison shopping among three product or service providers before making a “big ticket” purchase and talking to others before making a large financial decision.

 

In addition, some behavioral finance errors can be used in a positive way. Take mental accounting. It can be a valuable trait, such as establishing “no touch” accounts for college, retirement, or other financial goals.

This post provides general personal finance or consumer decision-making information and does not address all the variables that apply to an individual’s unique situation. It does not endorse specific products or services and should not be construed as legal or financial advice. If professional assistance is required, the services of a competent professional should be sought.