Have you ever wondered why you sometimes make financial decisions that, in hindsight, seem questionable? The truth is that even the most financially savvy among us can fall prey to unconscious influences that steer us away from optimal financial choices. This is where behavioural finance comes in.

Behavioural finance is a field that studies how psychological factors, such as biases in our thinking, can impact our financial decision-making. It acknowledges that we’re not always perfectly rational actors when it comes to money. There are numerous behavioral biases but for this article, I am going to focus on only 5 common ones. 

5 Behavioural Biases Affecting Your Finances

Traditional financial theory works with the assumption that humans are rational agents and are well-informed when making financial decisions. Behavioural finance, on the other hand, has shown that despite being well-informed, investors have shown irrational behaviors as they make decisions based on cognitive biases and emotions. 

It’s important that you understand and learn how to manage these cognitive biases and emotions as they can significantly affect your financial well-being. I have covered money and emotions in this article. In this article, I will talk about the common cognitive behavioural biases affecting your finances and how you can manage these biases when making financial decisions. 

Loss Aversion

No one likes losing money. But have you ever felt the sting of a financial loss more intensely than the joy of a gain? Loss aversion describes this phenomenon, where the pain of losing money can be psychologically more significant than the pleasure of gaining the same amount. 

Unfortunately, this can lead to overly cautious investment strategies that may not maximize returns. Why? Because you miss great investment opportunities out of fear of making losses. For instance, you may hold on to losing stocks longer than you should, hoping to recoup your losses rather than reallocating your portfolio strategically to mitigate further losses. 

Herd Mentality

Herd mentality refers to when people mimic the financial decisions and behaviors of a larger group. Rather than invest based on your research and analysis of the investment opportunity, you are influenced by the emotions and decisions of others. 

This bias can significantly influence investment markets, leading to inflated asset bubbles or steep crashes. A good example that illustrates the effects of herd mentality in Kenya is the Quail Eggs Meltdown of the 2010s.

Circa 2014, a new investment frenzy is making waves in Kenya—quail eggs. Quail farming was touted as a highly lucrative investment. Media reports and anecdotal evidence highlighted the high demand and significant health benefits of quail eggs, claiming they offered far superior returns compared to traditional poultry farming. As success stories proliferated, a rush of investors entered the quail farming business, driving the price of quail eggs and birds to unprecedented highs. Many individuals, influenced by the success stories and the rapid entry of others into the market, invested substantial amounts of money without a thorough analysis of the market or consideration of the investment’s sustainability.

This frenzy was a classic example of herd mentality, where the fear of missing out (FOMO) and the allure of quick profits led to irrational investment decisions. However, the market quickly became saturated, and the demand for quail products could not sustain the inflated prices. By 2014, the bubble burst, leaving many investors with significant losses as prices plummeted and they found themselves with stocks of quail eggs and birds far exceeding demand.

Overconfidence Bias

We all have a sense of our abilities. But do you overestimate your knowledge and skills when making decisions? That’s overconfidence bias. Overconfidence bias is a psychological behavior where individuals overestimate their knowledge, abilities, and the accuracy of their predictions, particularly in areas where they have some experience, such as investing.

This bias can lead to overly optimistic assessments of investment opportunities or financial decisions, often resulting in excessive risk-taking. For instance, you may overestimate your ability to predict market movements, leading to overly aggressive trading strategies that can jeopardize your financial stability.

Anchoring Bias

Anchoring bias occurs refers to when people rely too much on the first piece of information they receive when making decisions. This first piece of information is what’s referred to as “anchor”). 

When it comes to making financial decisions, it can manifest when setting price targets for buying or selling investments based on historical highs or lows, rather than on a comprehensive analysis of the asset’s current value and potential. 

This bias can lead to suboptimal investment choices, as you may become fixated on specific price points without considering broader market conditions or changes in the asset’s fundamentals.

Confirmation Bias

Confirmation bias refers to the habit of searching for, interpreting, recalling, and favoring, information in a way that affirms one’s preexisting beliefs or hypotheses. In the context of personal finance, it means that you may give more weight to financial information or advice that aligns with your existing opinions or investment choices, ignoring evidence to the contrary. 

This can lead to a lack of diversification, as you can fail to adjust your portfolios in response to new, potentially critical information, leading to increased risk and missed opportunities.

How to Overcome Behavioural Biases Affecting Your Finances

While behavioural biases are ingrained in our thinking. Fortunately, there are steps you can take to minimize their influence on your financial decisions: Here are 6 strategies to help you overcome behavioural biases affecting your finances

Awareness and Education

The first step in overcoming behavioural biases is to become aware of them. Educating yourself about common financial biases and how they manifest in decision-making processes helps you recognize these patterns in your behavior. Use resources like online courses, financial literacy workshops, and available free resources on social media pages and blog posts. 

Have a Financial Plan

A well-defined financial plan acts as your roadmap for your financial goals and actions. Every action you take, whether it’s investing in a particular asset or liquidating the asset, your financial plan will guide your actions. 

A solid financial plan must include your overall financial goals and investment goals. Your investment goals should include your risk tolerance, what assets you need to invest in, and even when to liquidate the asset. This will help ensure little to no reliance on emotions and impulsive choices when making financial decisions.

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Conduct Thorough Research

Don’t settle for the first piece of information you encounter. It’s important you conduct thorough research and learn as much as possible about the financial product or service you want to buy. It will help you understand what you are getting yourself into. 

Work with a Professional

Yes, DIY financial planning and investing is possible and can save you money from the service and management fees you’d have to pay a professional. However, working with a professional financial planner or advisor ensures you get invaluable expert advice and services about money management, including investing. They can also guide you when you have to make difficult decisions, ensuring your financial situation is protected as much as possible. 

Automate Your Finances

Don’t have the discipline to save or invest? Technology is your best friend. Set up automated transfers to your savings and investment accounts. For the management of investments, you can use Robo Advisors. These platforms use algorithms to manage investments based on the user’s risk tolerance and financial goals.  

Automating your finances will help reduce the influence of emotions and biases by establishing a consistent approach to financial management. If you are prone to following market trends without thorough analysis, robo-advisors offer a disciplined investment strategy that remains consistent regardless of market fluctuations.

Have Discipline and Manage Your Emotions

If you have read The Psychology of Money by Morgan Housel, you already know that success with money is all about your behavior. That’s where you need to have a lot of money discipline and learn how to manage your emotions. 

For starters, maintaining emotional distance from day-to-day market fluctuations and focusing on long-term financial goals can help mitigate the impact of volatile market conditions on your decision-making. Patience, on the other hand, is key in allowing investments to reach their potential over time, reducing the temptation to make hasty decisions based on short-term movements in the market. This approach encourages a more disciplined investment strategy, aligned with long-term financial planning rather than reactive decision-making. Remember, wealth is not overnight. 

Final Word

Understanding behavioural biases is a significant step toward achieving your financial goals. It will help you recognize what biases influence your money decisions and how they have affected your finances so far. This makes it easier to move forward, allowing you to formulate strategies and money behaviors that keep you grounded.