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How to Use Behavioral Finance to Your Advantage

August 14, 2020
sunk cost fallacy

We often don’t recognize the underlying factors and biases that affect our financial decisions. It’s easy to see where your problems lie; maybe you spend too much, save too little, or have more debt than you can handle. Recognizing your problems is the easy part. It’s much more difficult to understand the biases and behavioral aspects that played a role in those poor decisions. Once you know more about your behavior and biases, you can work towards making smarter financial decisions. What are some of the most common behavioral traps we fall into when it comes to money?

Sunk Cost Fallacy

Sometimes we continue a behavior that is no longer rational because of previously invested resources, such as time or money. If you buy a book for $20, and get halfway through it (it’s really good at first), you’re likely to finish the entire book because of the time and money you spent on it, even if the book is no longer interesting. People rarely leave movies early – even if the movie is terrible – why is this? We feel like we “get our money’s worth” by staying for the entire movie, even if we’re no longer enjoying it.

Life is precious and too short to waste time on something that isn’t worth it. The next time you find yourself reading a bad book or watching an awful movie, remember that the time and money you previously invested is already gone. You can, however, keep yourself from wasting any more time if you walk away from sunk costs.

Mental Accounting

A dollar should always be worth a dollar, right? Where money comes from doesn’t make it worth any less or more than other money, but we still assign different values to funds from different sources. Money we get as a gift is more likely to be spent on something we enjoy than money we earn through work. Unexpected windfalls, like lottery winnings, are also more likely to be spent on wants rather than needs. Some people even value cash more or less than money in the bank. Avoid the trap of mental accounting by treating all money you receive like it all has the same value, because it does.

Invisible Social Contracts

Much of the sales world is built on invisible social contracts. When someone is selling something, they may first offer you something of value to create a feeling of goodwill and increase your likelihood of purchasing whatever they are selling. This happens all of the time with free samples, free dinners if you sit through a timeshare presentation, and test drives at car dealerships. Many of us feel guilty for breaking these invisible social contracts, which is why they can be so effective. 

The Money Guy Show is another example of an invisible social contract; we provide free resources and information through the show in the hopes that one day you’ll reach a certain level of success and come back to the place where it all started. Social contracts aren’t necessarily bad, but they can be if the product you are buying is no good. If you are susceptible to invisible social contracts, maybe you should think twice before going to your next free timeshare dinner.

Overconfidence Bias

One of the most dangerous biases that almost everyone is susceptible to is overconfidence bias. A study conducted a few years ago found that 65% of Americans believe they are more intelligent than average, and less educated Americans are actually more likely to believe they are above average than highly educated Americans. 

Overconfidence bias rears its ugly head often in the world of finance. The stock market is unpredictable, and economists are unable to consistently and accurately predict recessions. Yet so many investors think they can time the market and simply pull money out when the market is at a peak and invest back in when the market is at the bottom. Actively managed funds consistently underperform their respective indexes, yet average investors believe they have the ability to pick funds that can beat the market. Stay grounded in your own abilities, and recognize your limitations. Knowing what you don’t know can keep you from becoming too confident in your own decision making.

Loss Aversion

For some of us, losses bring more pain than gains bring pleasure. Imagine you buy a lottery ticket one day and it turns out to be a million dollar winner. On the drive home with your winning ticket, you’re picturing everything you’re going to do with the money, like buy a vacation home, a new car, and that big screen TV you always wanted. You are so distracted that you didn’t notice the lottery ticket flying out the window 10 miles back; you immediately go back to search for the ticket but have no luck. The money is gone for good.

Now, if you could do it all over again, knowing you would lose the ticket forever and never collect your winnings, would you still choose to buy the million dollar ticket? Probably not; the anguish you feel from losing the ticket is greater than the joy you felt from winning the million dollars.

Loss aversion bias occurs frequently with investors, too. Some would rather allocate their portfolio to cash and wait for an opportunity to get into the market rather than risk investing at the top and suffering a loss. 

Our latest show is all about behavioral finance and the different biases we have when it comes to money. Not only do we cover everything listed here, we talk about even more factors and biases you need to be aware of in “9 Dumb Financial Decisions Most People Make (Do You?!)” Watch it now on YouTube below.

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