The Psychology of Money: Understanding Behavioural Biases in Financial Planning

Jun 15, 2023 / Reading Time: Approx. 6 mins

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As a financial writer, I have immersed myself in various books on money and financial management throughout my career. Recently, I came across an intriguing book titled “Psychology of Money” by Morgan Housel, a partner at The Collaborative Fund. Published in September 2020, amidst the challenging backdrop of the Covid-19 pandemic, this book resonates deeply with many of us. This book explores the psychological aspects of finance, offering valuable insights into our money-related behaviours and attitudes. It teaches us important lessons about understanding our biases, embracing simplicity, and making wise financial decisions. The book imparts timeless wisdom to help individuals develop a healthy relationship with money and achieve long-term financial well-being. Inspired by the insights shared in Morgan’s masterpiece, I am compelled to delve into the subject deeper and share my reflections with you today.

We all have different financial situations and goals, and our financial journeys largely depend on our hopes and dreams. As individuals, we all have unique relationships with money, and the way we manage it can significantly impact our financial well-being. While it is tempting to attribute our financial struggles to external factors such as a lack of funds or market volatility, it is essential to recognise the role that our behaviour and choices play in shaping our financial outcomes. Our actions, biases, and beliefs about money can overshadow the influence of these external factors, making them the primary culprits for our financial challenges. Psychology offers valuable insights into understanding the complex dynamics between human behaviour and financial decision-making. By understanding the psychology of money, we can get answers to why we make certain financial choices and how these choices affect our ability to achieve our financial goals.

What Is Behavioural Finance?

Behavioural Finance is a multidisciplinary field that investigates the impact of human behaviour on financial decisions and market outcomes. It recognises that individuals are not always rational and objective when it comes to making financial choices and seeks to understand the psychological factors that influence these decisions.

Unlike traditional finance theories that assume individuals always act in their best economic interests, behavioural finance acknowledges that human behaviour can be driven by emotions, biases, cognitive limitations, and social influences. It explores how these psychological factors shape financial decision-making processes and can lead to both beneficial and detrimental outcomes.

One key aspect of behavioural finance is the examination of biases that individuals often rely on when making financial decisions. These biases, such as overconfidence, loss aversion, and anchoring, can distort our judgment and lead to poor investment choices. By identifying and understanding these biases, behavioural finance offers insights into why individuals may deviate from rational decision-making and make predictable mistakes.

Moreover, behavioural finance recognises that individuals are influenced by their own beliefs, preferences, and values, which can cloud their judgment. It highlights the importance of considering subjective factors in financial analysis and understanding how psychological biases can create market inefficiencies and anomalies.

By studying behavioural finance, we understand the limitations of traditional economic models and how psychological factors can significantly impact financial markets. This understanding opens the door to developing strategies and techniques to mitigate the detrimental effects of behavioural biases and help in making more informed and rational investment decisions.

What Are the Behavioural Finance Concepts?

Behavioural Finance is about how our behaviour affects our money decisions. There are five important concepts in behavioural finance:

  1. Mental Accounting: This is when we assign money to specific purposes. For example, treating a tax refund as if we earned some extra money when it is actually our own money coming back to us.

  2. Herd Behaviour: This is when we follow what others are doing without thinking, for example, buying a specific stock or mutual fund just because your colleague has bought it without considering if it is a good financial decision.

  3. Emotional Gap: Our emotions can affect our decision-making. When we are stressed, angry, anxious, fearful, or excited, our emotions can lead us to make choices that are not rational. For example, buying high health insurance coverage after the sudden demise of a close friend/relative due to a medical issue without understanding your health and insurance needs. Another example could be investing a large portion of your savings into high-risk investment avenues after a small gain.

  4. Anchoring: We tend to rely too much on the first piece of information we get. For example, if you see a home decoration item costing Rs 10,000 and another item priced at Rs 2,000, you might think the second item is cheap. But if you had not seen the first item, you would not view the second item as inexpensive. The first price you see influences your judgment.

  5. Self-attribution: This is when we make choices based on overconfidence in our own abilities. For example, we might pay off debt more often than we save because it makes us feel good about ourselves. You can overcome this by setting up automatic bill payments, including saving money, so we prioritise saving.

The Psychology of Money: Understanding Behavioural Biases in Financial Planning
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What Are the Biases in Behavioural Finance?

When we dig a little deeper into behavioural finance, we find that it is all about understanding how personal biases and tendencies affect investors' choices. These biases often lead people to make illogical or harmful choices when it comes to money. Let's take a look at some common biases:

  1. Confirmation Bias: This happens when people only look for information that supports what they already believe. They ignore or dismiss information that goes against their beliefs, creating a cycle where they reinforce their own ideas.

  2. Experiential Bias: This bias occurs when an investor's memory of recent events makes them think that the same thing will happen again. For example, a recent gain or loss in the investment makes investors believe that investing in the same investment avenue will repeat the past.

  3. Loss Aversion: This bias happens when investors are so scared of losing money that they prioritise avoiding losses over making financial progress. Studies have shown that people feel the pain of a loss more strongly than the joy of making a profit.

  4. Familiarity Bias: This bias occurs when investors prefer to invest in things they are familiar with. For example, many people in India still believe that traditional investments like Bank FDs, real estate, and gold are the best investments because their parents and grandparents have been investing in it, and they probably have the basic knowledge of these investment options. However, this can lead to a lack of diversification, which can increase risk.

These biases can cloud our judgment and lead us to make poor financial decisions. By recognising and understanding these biases, we can overcome them and make better choices for our financial well-being.

How to Overcome Behavioural Biases?

Can we completely avoid or ignore our financial biases? Not really. But being aware of these behavioural tendencies can be helpful. Here are a few tips:

  1. Create a Long-term Financial Plan: Having a solid financial plan can help you make decisions based on logic rather than emotions. It can prevent distractions or short-term challenges from affecting your financial choices.

  2. Emphasise the Negative: As discussed earlier, losses give us more pain than gains make us happy. Hence, you should focus on the negative aspects of financial decisions. For example, instead of thinking about creating a nest egg for the future, you can think of how saving money helps you avoid debt and bad budgeting.

  3. Track Your Money Decisions: Try to keep a record of the money decisions you make and why you made them. Review your choices periodically (preferably monthly and yearly) to see if you made any hasty or incorrect decisions. This can help you avoid overconfidence in future money decisions.

  4. Step Out of Your Comfort Zone: If everyone around you thinks and does the same things with investments, try opening yourself up to new opposing views and strategies. You must be mindful that opposing views may not always be correct, but being open to different perspectives can help you differentiate between blindly following the crowd and making informed financial choices based on research and understanding.

  5. Remember Money Is Interchangeable: If you unexpectedly have extra funds, take the time to figure out where they can have the most positive impact on your overall financial situation. Consider how they can contribute to your financial well-being in the best way possible.

Conclusion:

Understanding the psychology of money and behavioural biases is crucial for effective financial planning. To navigate these biases, it is essential to create a long-term financial plan, emphasise the negative to prioritise avoiding financial pitfalls, track your money decisions to identify patterns, step out of your comfort zone to explore new perspectives and consider the interchangeability of money to maximise its impact. While we cannot eliminate biases, incorporating these strategies can help us make sound financial decisions and move closer to our goals.

 

KETKI JADHAV is a Content Writer at PersonalFN since August 2021. She is an MBA (Finance) and has over seven years of experience in Retail Banking. Ketki specialises in covering articles around banking, insurance, personal finance, and mutual funds and has been doing it for over three years now.


Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.

Disclaimer: This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision.

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