Have you ever taken a retrospective look at your financial decisions and discovered they weren’t the best ones? Whether it was excessive spending on an impulse buy or a lack of self-control in conserving money, a lot of individuals are dissatisfied with their own actions. These actions-which sometimes do not seem coherent-are what the study of behavioral finance addresses.
Behavioral changes, examined from both a psychological and economic perspective, shed a little light on how people decide on particular courses of action. Coupled with mapping out actions, this sort of information helps an individual to stay clear of all mental traps, including those that have to do with money. If you want to learn how not to make bad financial decisions, keep reading to better understand what behavioral finance is and the main principles of this concept. Also, learn how our behaviors affect personal finances and how to use this sphere of economics to our benefit. Enjoy your reading!
What is behavioral finance?
Emotions, beliefs, and psychological factors that influence people’s financial decisions are all studied in the topic of behavioral finance, which is a branch of economics. In this approach, this study makes the assumption that people don’t always act logically and sensibly while handling money. Instead, it assumes that we are often guided by impulses and emotions , which can lead us to make choices that are not always ideal. By understanding more about how behavioral finance works, it is possible to better understand our way of acting. Thus, it becomes possible to find ways to overcome impulses and adjust our decisions, improving our savings, investments and spending habits.
What are the main principles of behavioral finance?
Understanding the underlying ideas is the next step after learning what behavioral finance is. To assist you comprehend each one, we have included many examples to accompany our explanations. See additional details below.
Confirmation bias
The first behavioral finance principle you need to know about is confirmation bias. It’s related to the habit we have of trying to confirm our beliefs through information from other people, ignoring data that creates contradictions. For example, if you believe that a purchase you decided to make even though you didn’t need it is a good choice, you will start looking for news or analysis that confirms it, ignoring critical information that suggests otherwise.
Loss aversion
Another principle that can hinder your development and pursuit of financial independence is loss aversion. In theory, it refers to people’s tendency to avoid losing more than they avoid making gains. In this case, you tend to feel much more pain when losing R$100 than the joy of winning the same amount. This type of situation leads people to make conservative financial decisions to avoid losses, even if it means letting opportunities for gains pass them by.
Herd effect
This is the well-known behavioral finance axiom, “Mary goes with the others.” Simply said, the herd effect is the tendency for people to make automatic financial judgments based on crowdsourcing rather than independent thought. For instance, even if you don’t completely understand what you’re doing, you can feel pressured to invest in financial pyramids if everyone else around you is.
Anchoring
You know when you see an item sold on the internet with information that the initial price was 3X higher, but that it is now being sold for only X? Even if this information is not true, it ends up creating the perception that it is much cheaper, which can lead you away from the path of conscious consumption. In other words, anchoring is the tendency to give too much weight to initial information when making financial decisions, understanding that the suggested value is now a “good deal”, even if the real market value is much lower.
Availability
This principle is related to the extreme value given to information that is more recently available. This principle can lead you to make wrong financial decisions, which can hinder your management. This often happens when you hear negative news about the stock market, regarding events that occurred a week earlier but have already changed, given that the financial world is very dynamic.
Overestimation of abilities
This principle is related to the habit of understanding that, for some reason, some skills and knowledge are above average for others and, therefore, can do better. Suppose you are about to buy a property and believe that you are an excellent negotiator. However, during the negotiations, you come across complex terms, unfamiliar real estate regulations and confusing contractual details. In this case, overestimating your financial skills hinders your ability to make effective decisions, which can lead you to make a bad deal, resulting in your finances being compromised.
The status quo
The propensity of people to persist with their current financial decisions, even when they aren’t the greatest ones, is known as the status quo principle. Debt buildup may eventually result from this kind of activity.
For instance, instead of exploring for alternatives with cheaper costs, you could keep your high-fee bank account open merely because you’ve always had it.
What impact do our actions have on our personal finances?
Our own financial situation is directly impacted by the way we operate. We have the power to alter our monthly spending patterns, income streams, and even how we feel about money. View further details on these effects below.
Consumption habits
Our behavior can directly influence how we spend money. For example, if you adopt impulsive spending habits and don’t learn how to deal with it, you may end up spending more than you earn and, as a result, accumulating debt . Therefore, it is very important to invest in financial education to avoid this scenario.
Lack of control
When you don’t have financial control and adopt a strategy in which you spend more than you earn, it’s natural to end up having difficulty paying your bills and eventually going into the red. Therefore, it’s important to have conscious consumption habits to avoid this situation.
Unnecessary risks
You need to know how to balance financial risks. For example, if you are just starting out on your journey, seeking professional guidance and studying to understand more about how to manage money is very important. As you gain more knowledge, it becomes more reasonable to take risks in investments.
Planning
With new knowledge and a better understanding of how our behaviors work, it becomes easier to find balance and define a financial plan to get out of debt, achieve independence and have security. Therefore, adopting the habit of studying the subject is crucial.
Life changing
As you have seen, the way you relate to money and adopting a learning routine can help you move from a situation that generates debt to one that provides financial peace of mind. Therefore, finding out tips on how to use behavioral finance is a great idea.
How can I use the principles of behavioral finance to my advantage?
Once you understand a little more about psychology applied to finance and how it affects financial decisions, you can use these principles to avoid biases and create a more rational path for your choices. See below how to implement this in practice.
Self-knowledge
The first step to avoiding bad behavior is to know your limits and behaviors, especially when it comes to money. Doing a self-assessment allows you to identify habits, bottlenecks, and situations that can be avoided. In addition, you can identify moments that can trigger impulsive decisions. For those who know that a trip to the mall can instigate compulsive shopping, for example, it is easier to avoid this type of environment that can lead to irrational use of money.
Clear budget
Setting budget limits is a great strategy to train your mind and avoid imbalances in your finances. In addition to exercising your discipline and responsibility, this behavior favors a more balanced use of money. So be sure to use spreadsheets, personal finance apps or even a simple record in your diary to establish amounts for everything. Be sure to set aside an extra amount for unforeseen events or even for a personal treat, as a budget that is too rigid can also be difficult to maintain.
Debt negotiation
A good way to use anchoring is to look for ways to negotiate your debts and get better terms to pay them off. By defining a clear budget, you are better able to include a monthly amount in your planning to direct towards paying off your financial debts. In addition, it is a good idea to count on debt negotiation experts.
Financial education
To be a conscious consumer, it is important to invest in knowledge. Even though many people have an inefficient relationship with their money, mathematics prevails. This means that, regardless of the situation, those who spend more than they earn tend to get into trouble. Therefore, consuming content on blogs, videos, podcasts and free online courses is an excellent way to learn more about the dynamics of money, the complexity of credit, the effects of inflation, the possibilities of remuneration and other important elements for managing your money.
Investment automation
The financial market is one of the most difficult environments to maintain rationality. Especially for those with little experience in trading assets, it can cause a great emotional impact due to short-term fluctuations. A good way to exercise financial control can be through investment automation. This allows biases linked to macroeconomic events to not affect the decision-making of assets that can be acquired. Determine a monthly amount to invest efficiently in low-risk assets. This way, you can maintain a balanced portfolio without suffering emotional impacts.