Family behavioral finance looks at how psychological influences impact our economic market. This kind of study can help predict different market outcomes across a variety of industries. It takes one’s finances and examines the behaviors and influences surrounding spending and how individuals may use their income based on psychological biases. Understanding behavior finance answers questions like, “why do I spend so much money? And “how to cut down on retail therapy?”
Behavior finances consider your family and personal economic life and studies how you value money and how you might behave with your finances. An example of this would be if you go out every Friday for dinner – this behavior impacts your financial situation one way or another. By studying these behaviors associated with spending, psychologists can make predictions on how a family may behave with their finances.
There are typically five components to family behavioral finance. These include mental accounting, herd behavior, emotional gap, anchoring, and self-attribution. Being aware of these behavioral finance elements can help you spot their impact on your financial decision-making.
Richard Thaler, a Nobel Prize-winning economist, first introduced the concept of mental accounting in 1999. This economic idea surrounds the various values consumers place on their money. Typically, mental accounting may lead families to make investment decisions that are not the most ideal for their financial health.
Mental accounting can often cause a counterproductive investment choice. For example, a family may have high credit card balances, yet choose to save cash in a shoebox in their closet. This kind of choice provides no return on investment, while the high credit card balances wreak havoc on their credit score.
When it comes to battling mental accounting, families should think of money as fungible, or interchangeable. Whether a family is budgeting for bills or adding to an investment account, they should consider that money is convertible and 100% theirs to decide how best it is applied.
Herd behavior in economics refers to the way people mimic others’ financial decisions. Herding is notorious in the stock market, as people watch other investors’ purchasing choices and sell-off choices.
If an investor decides to follow the herd and copy what other investors are doing with their stocks and funds, they are participating in, and fueling, herd behavior. This behavior can start dramatic market rallies or sell-offs that do not justify the volatile behavior. Do your research, develop your analysis, and take the risks that make the most sense to your financial portfolio, not another’s, to avoid falling into herd behavior.
The emotional gap refers to when a consumer makes decisions based on emotions. These decisions are often tied to extreme feelings, such as anger, fear, anxiety, and even excitement. When it comes to investing and making financial decisions, it is usually in a consumer’s best interest to stick to their financial plan.
Another way to avoid falling into an emotional gap is to work with a financial advisor to decide how open to risks a consumer might be. The market will always fluctuate between bullish and bearish. If anxiety and fear of loss may impact financial decisions, it could be best to disclose that to a financial professional early in the investment planning.
Attaching a spending level to a reference point is how economists describe anchoring. It is visible in a consumer’s monthly budget or investments. Anchoring can be beneficial to consumers who may be able to influence price negotiations in their favor, but it can still skew one’s decision-making around their finances. In anchoring, the consumer typically has a subconscious item linked as their fixed reference point to make decisions.
Self-attribution is the tendency to make decisions based on overconfidence in one’s skill or knowledge. This tendency can go positively or negatively for a person. They may take credit for any market success or attribute losses as potential ill-intent from others when it is neither of the two. This approach can keep investors from learning and growing their skill sets and even can cause mistakes if not careful. It is important to view the market without self-attribution attached to it and make decisions based on what is best for the current situation.
Behavioral finance proposes that psychological influences and biases affect the financial behaviors of investors and financial advisors, too. Being aware of the five main concepts of family behavior finance can help investors and their families make sound financial decisions that are not rooted in others’ decisions, emotions, or outdated skill sets.
If you are considering partnering with a financial professional that is ready to make decisions based on research and personal analysis, give TSP Family Office a call at (772) 257-7888.