Behavioral Finance

Welcome to Season 2!
Join our new host Nikita Wolff & Co-Worker Nicole as they discuss behavioral finance; particularly what the main components of it are and how we can avoid falling into common psychological traps. 

In this episode, they discuss:

• Mental Accounting
• Herd Behavior
• The Emotional Gap
• Anchoring
• Self-Attribution
• Confirmation Bias
• The Relativity Trap
• Irrational Exuberance
• The Superiority Trap

Transcript

Nikita: 0:00

Hey, 3rd Decade community. Welcome to season two of the 3rd Decade podcast. I'm your new host. And if you don't remember me from last season, I'm Nikita Wolff, 3rd Decade's program manager. Our hope in this upcoming season is to continue building out a robust set of resources to help you in your financial journey or just something to listen to in your downtime if you're a finance nerd like me. Either way, we're happy to have you. Today. I'm joined by my coworker, Nicole, to discuss behavioral finance. Behavioral finance is a subfield of behavioral economics that aims to highlight the likely psychological influences that all of us face that impact our financial behaviors. And more than that, these influences and biases can help make sense of some of the things that happen in the market. If we're able to interpret the information given to us by behavioral finance, we might better understand different outcomes across various sectors and industries. And more than that, if we learn what to look out for, we can avoid falling into these behaviors ourselves. Thanks for joining me today, Nicole

Nicole: 1:12

Thanks for having me!

Nikita: 1:14

I'll start us off with mental accounting. Mental accounting refers to the different values that a person, places on the same amount of money, and this can end up being really counterproductive and lead to negative outcomes. It contends that individuals classify funds differently and therefore are prone to irrational decision-making in their spending and investment behavior.

Nicole: 1:33

You know, there are really quite a few examples, but the top three for me are people who fund a low-interest savings account while they still carry a very large balance on a credit card. Making additional payments to a principle of their mortgage while only contributing 5% to retirement accounts. And I think kind of the biggest one is our willingness to pay for goods using a credit card, because we'll pay more on the credit card than we will when we're using cash. And this phenomenon is called payment decoupling because there's a separation of when the good is acquired and then when it's actually paid for. So we just don't really think of that big cost as being an upfront cost to us.

Nikita: 2:08

Right? The best way to avoid the mental accounting bias is to just try to treat all of your money the same, whether it be for everyday living expenses, discretionary spending debt payoff, or savings in retirement accounts.

Nicole: 2:21

And another really great example is the difference in how, how people value a dollar earned on a paycheck versus when it's given to them. So for instance, a number of people who use their tax refunds each year as found money to spend on discretionary items and that's okay, but really in reality, this money is not found. It was always yours to begin with, and that's why we call it a refund. So you can definitely spend your refund on discretionary items, but really you need to be viewing those funds the same way as your regular income.

Nikita: 2:48

Yeah. I find myself doing this with cash a lot of the time too, which I think is something that the switch kind of flipped for a lot of millennials. I know the envelope method is a common budgeting technique that argues that spending cash feels more tangible than swiping a card. But for me, it's the complete opposite because I'll actually go through and tally each of my expenses throughout the month. And if I don't have a paper trail for my cash spent, it kind of just feels like free money to me. So I typically have a less emotional response to using it, even though I know logically I should be treating it all the same.

Nicole: 3:22

I mean, I think we all do this. So one way that my household has tried to avoid mental accounting is really taking a look at our spending habits and then creating accounts with the monthly allotment for each category. So last year we had some pretty lofty savings goals and we decided to really do a deep dive into a month spending and then make some big spending cuts. So since I do the bulk of the grocery shopping for the household, I kind of had a rough idea about what we spent on groceries each month, but we really broke it down into meats, dairy bread, desserts, alcohol, and that was really eye opening.

Nikita: 3:55

I'm sure.

Nicole: 3:56

So that way you can be more strategic with your funds. And so do I want to do this week or will I have a better outcome with something else? And so, yes, that's a small example, but taking these small things kind of turned into a big impact,

Nikita: 4:06

Bringing that to our next point, herd behavior is one that more people are familiar with. And that's the idea that people tend to mimic the financial behaviors of the majority of the herd. This is especially common, unfortunately, in the stock market and some good examples of it can be seen in the game stop craze of 2021 or the financial crisis in 2008, whenever so many people cashed out their retirement savings and locked in their losses, whereas people who rode the wave and didn't change anything about what they were doing, would've seen the same predictable gains that we've been seeing from long holding periods in the last several decades.

Nicole: 4:41

Yeah. I agree with this. I mean, I think we all sometimes wanna hop on the bandwagon to do things, but we really wanna avoid this. We want to make investments on sound principles and do it with through objective criteria and not when emotions take over.

Nikita: 4:55

Right.

Nicole: 4:56

And so I think you could also use this as an opportunity to buy when others are panicking and picking up assets when they're on.

Nikita: 5:02

Yeah, exactly. And so to build off of that, the emotional gap is another component of behavioral finance and it refers to the decision making based on extreme emotions or emotional strains, such as anxiety, anger, fear, or excitement. We all know too that decisions made under pressure or with emotions overly involved. Don't often lead to good out outcomes.

Nicole: 5:22

Yeah. I mean, and I think this is a good time to talk about comfort level. There are industry standards to how to set your stock allocations. But if that doesn't make you feel good, you're gonna have irrational fears when something happens in the stock market and you're making these big changes. So you really, again, wanna do this in a sound state of mind. So it helps you avoid these pitfalls of making and changing investment strategy when there are stressful circumstances happening.

Nikita: 5:44

Right. And what Nicole's referencing here is that you'll hear some people are proponents for people in their twenties and thirties to have, you know, up to a hundred percent of their portfolio in diversified stocks. But there are other people in the industry who see that as a huge risk and would say, no, you should have, you know, 80% in stocks, 20% in bonds, or, you know, some variation on either side of that spectrum. But the, the point is, if it's not a plan you're going to stick with, and you know your own risk tolerance, it's a waste of time to say, okay, y eah, I'll go into a hundred percent stocks- if the second you see a dip, you panic and you sell all of it. That's not an allocation strategy that works for you.

Nicole: 6:29

Exactly.

Nikita: 6:30

Another behavioral finance component is anchoring, which refers to the irrational bias that we have towards an arbitrary benchmark figure. And in the investing world, this can impact decision making for something such as when it's time to sell an investment. As a result market participants end up assuming greater risk by holding onto an investment in the hope that it'll return to its purchase price. And most people know that this anchor is imperfect, but it doesn't change the fact that the outcomes still reflect the bias of the original anchors. You'll also see this at play within wage and price negotiations setting. The anchor point before negotiating ever happens will have more of an effect on the final outcome than the negotiation process itself.

Nicole: 7:09

Yeah. I mean, this is, this can be really problematic when you're overly confident in a company's value, regardless of what the data's saying. Take, for instance, in the companies we thought would be around forever. Toys R Us, Sears.

Nikita: 7:19

Yeah. Blockbuster.

Nicole: 7:22

And so I think that those companies do not exist anymore. And I think there is actually one blockbuster left in some small town in Alaska, but really they don't exist anymore. Right? So we really wanna combat this trap. And the key here is to stay open minded about new information that might challenge what you previously believed.

Nikita: 7:40

Self attribution is another one and it refers to a tendency to make choices based on overconfidence in one's own knowledge or skills. This is a common, emotional bias to have, especially for those who listen to a lot of finance podcasts or are involved in the financial industry in other ways. In psychology, self enhancement is the tendency for individuals to take all the credit for their successes, while giving little or no credit to other individuals or external factors. The flip side of this is when people attribute their losses as being influenced by factors beyond their control. This can easily impact investors because they may attribute luck to skill and allow a past experience to make them overly confident about their abilities.

Nicole: 8:18

Yeah. And if anyone is listening who took the 3rd Decade class, you remember there was a skittles chart that we showed and this just really showed you how random the market can be. One year a stock can be at the very top. The very next year can be very, very bottom. And so you just wanna be kind of careful as you're making these assumptions of what, you know, based on what other people know in the industry.

Nikita: 8:36

Right. Sometimes it can really feel like there is no rhyme or reason. It's also important to note that while some of the time you might get lucky and your choices align in a favorable way for you. We've also seen that monkeys can perform and even outperform, actively managed funds.

Nicole: 8:52

And there's a great example of this. Warren Buffet is the quintessential index fund believer. And he made a bet with a hedge fund manager in 2007. He said, Hey, if we, if I just held the S&P 500 an index fund, it will beat you and all these hedge funds over how much money they're gonna make over these 10 years, the hedge fund guy thought, I know what I'm doing. I know more than you. And he was wrong. The results were resounding victory for low cost index funds over the high cost hedge fund managers, the returns over the 10 year period for the five hedge funds ranged from 0.3% to 6.5% annually, where the S&P 500 was 8.5% annual return over that full 10 year period.

Nikita: 9:34

Wow. Yeah, that's definitely a good example of how advantageous it is just to set up a system that works for you, automate it in a way that allows the market to do with your money, what it does. And then it also helps take some of that pressure off of us to feel like we need to be good at investing, but it also saves us significant money and fees. So as we always preach, index funds are the way to go. So let's take some time now to shift over to some of the common, psychological traps that people can fall into.

Nicole: 10:05

So one that I think that we are all really guilty of is the sunk cost fallacy. This is our tendency to hold onto things that we've already invested a lot of time and money into, simply because it feels less like a loss than if we just walked away from it entirely. So in terms of time, the sunk cost fallacy can really apply also to relationships and staying in them, even when you're unhappy, simply because you've been together for a long time.

Nikita: 10:28

Yeah, I see that a lot. I think we can all be guilty of this.

Nicole: 10:32

Yes. And so I have a real life material example of this brother-in-law moved away. And so he's packing up his belongings dissembling, a desk that he knew he would never be able to put into his new place. It did not fit. However, he didn't wanna leave it behind because he had spent so much time and money picking it out. So beyond the material example, this can also apply to you holding onto an investment that's been performing very poorly for a number of years. That emotional commitment to seeing a decision through simply because it's hard to admit defeat is really only gonna make things worse in the long run.

Nikita: 11:03

Yeah, I couldn't agree more. Confirmation bias is another trap that's easy to fall into with our media sources being more targeted than ever. It's easy to see the thoughts and opinions of people who are exactly like us. Plus we're way likely to listen to somebody. If they're saying something that we already agree with, then if their ideas are challenging, ours, this can become an issue in investing. When you're listening to someone, maybe even a company give biased opinions on what financial decisions you should make.

Nicole: 11:30

And along those lines, I think we need to be careful of the talkers and influencers who are also kind of sharing what they think might be real, really good advice, but they could also be being sponsored by these companies that may not have our best interest at hand.

Nikita: 11:43

Yeah. Either sponsored or just incorrect.

Nicole: 11:46

Yeah. I agree with that. So the relativity trap comes into play when we are comparing ourselves to others without knowing the whole situation. And so we don't wanna compare our strategy or what we have in our life to somebody else who's been dealt a completely different hand.

Nikita: 12:00

Yeah. I absolutely agree with that. Irrational exuberance is another one. This is when an investor maintains blind optimism and ultimately leads to an overvalued stock market. Anyone who thinks that the market's going to keep outperforming itself year over year, doesn't have an accurate foundation of historical data on the stock market. And that's why it's so important to establish a long term plan, knowing that bull markets and bear markets are all part of the equation. I don't remember where the quote is from. Um, it might be Warren buffet actually, but saying basically if you don't plan to hold a stock for at least 10 years, you should never buy it in the first place

Nicole: 12:36

That is warren buffet. Yes.

Nikita: 12:38

Yep. Yeah. I think that's a good example of that.

Nicole: 12:41

It absolutely is. Yes. So lastly, we have the superiority trap and this is something we see all the time from the talking heads of the finance industry, the Suze Orman's& Jim Cramer's. And really just because they spend a lot of time researching what the next big stock might be, doesn't mean they actually have any advantage over somebody else.

Nikita: 12:59

One more closing remark that I'd like to make, because I've seen it in my own social media feed is that when you have friends sharing, when they've gotten great returns on a specific company stock, just remind yourself that they don't publicly share when they lose money only when they win. So it's a losing game to think that buying individual stocks is a retirement plan. We hope you enjoyed today's episode. If you have any questions or topics that you'd like us to cover, feel free to write to us at info@3rddecade. org. Thanks for sharing your time with us. And you'll hear from us again soon. Take care.