If you are feeling stuck on how to handle your personal finances that have been on decline for a while now, it might be time for a change in your point of view. If you come to think of it, personal finance is a lot like corporate finance. Every day you get to make executive decisions about where to invest your income, assess risk and reward, while there is also a certain cost-of-carry involved in maintaining your household and lifestyle that allows your most valuable asset (you and your working power) to continue generating revenue – think of it as ensuring your position in the (job) market.
What is Behavioral Finance and How Does it Work?
You might believe that the way people approach personal finance is completely different to how financial practitioners make decisions. Yet behavioral economics invites you to rethink that assumption. Behavioral finance – which has been dubbed “open-minded finance” – is a psychology-based approach on stock market movements that links them to the emotions and behavior of investors – much like the way we tend to think about personal financial decision-making. According to a leading authority in this field, Hersh Shefrin, who is a finance professor at Santa Clara University, investors are prone to what he calls “heuristic-driven bias”. This notion describes the fact that they tend to underestimate statistics, probabilities and other objective data; instead, they rely on intuition, past experience, and trial and error. Sounds familiar?
Shefrin also believes investors rely heavily on “stereotypes” – which means, for example, believing that blue-chip stocks will necessarily continue to provide consistently high returns. This might also explain how the stock market indices like FTSE 100 are structured: FTSE 100 represents the largest 100 companies traded on the London Stock Exchange and goes up and down according to their share price performance, while price-weighted indices like Dow Jones and Nikkei also revolve around higher-performing shares since they award them more influence. In essence, people tend to rely on past performance and develop very specific expectations that derive from it.
How Does this Fit in with Personal Finance?
Behavioral finance is based on the premise that people tend to make the same mistakes and repeat the same patterns of behavior. To put it in a nutshell, whether you are a bull or a bear by nature will inform your financial decision-making process. Therefore if you are able to work through you own financial behavior pattern and establish your thinking process, it might allow you enough clarity to explain past investment mistakes and avoid them. It also will enable you to pinpoint in which areas you are underperforming and why.
You can start by making a list of observations about your financial behavior – write down your income sources, both your regular and unexpected expenses, as well as your investments, whether is it saving up to buy a house or your retirement plan. You can now reflect on your sentiments that lie behind your decisions: for example, do you tend to spend more or make more impulse buys when shopping in the first few days of the month – that is, when you have just cashed your monthly paycheck? That is described as “frame dependence” in behavioral economics: being over-confident when things are going well. Or, do you demonstrate availability bias – basing your shopping patterns on product information that is readily available rather than taking the time to dig deeper and identify better value for money deals?
These are just a few tips on how you can make your own behavioral finance assessment on your personal spending habits. Make it your personal project – it might require hard work and some time to prove fruitful, but it also promises high reward!