Behavioral Biases
That Might Affect Financial Decisions
As emotional beings, every interaction, every experience subtly shapes our beliefs, our decisions, and the way we perceive our reality.
Personal bias is the lens through which we favor or judge the world around us. It’s instinctual, designed to help us make sense of complex information. But if left unchecked, these biases can lead us astray—especially in decisions that require careful judgment, like those involving our finances. In fact, when making financial decisions, personal biases often influence even the most minor choices, sometimes without us realizing it.
While biases are a natural part of human psychology, developing an awareness of how they manifest may support well-informed, objective financial decisions. By recognizing these patterns, we could expand our understanding and possibly avoid common pitfalls.
Below are five common behavior biases that may influence our financial decisions, revealing remarkable insights into the psychology behind investment behavior.
So, what exactly derails us, and how might we sidestep these traps?
5 Behavioral Biases That May Misguide Us
Behavioral Bias #1: Loss Aversion
When we feel the sting of a loss twice as intensely as the thrill of a win, that’s loss aversion at work. (And isn’t it just like us to fixate on the negative?) This instinct is rooted in our psychology—it’s our brain’s way of protecting us from the perceived threat of losing something valuable. While this can be helpful in dangerous situations, it may also lead us to avoid risks and resist change in areas where some level of risk-taking might be beneficial, such as in our financial lives.
For example, you might hesitate to sell an underperforming stock, hoping it will eventually recover, even if a better option is available. Instead of minimizing losses, this approach may lead to a deeper financial setback over time. In investments, loss aversion often manifests as a reluctance to cut losses on a declining asset, even when evidence suggests that selling may lead to a stronger long-term position.1
Red Flag: “I’ll hold for now.”
If you find yourself rationalizing a decision to cling to a losing investment, it may be loss aversion steering your choices.
How to Counteract Confirmation Bias:
Reframe Your Mindset: Shift your focus from the loss itself to the potential for growth. Ask yourself, “What might I gain by making a change?”
Behavioral Bias #2: Confirmation Bias
Confirmation bias is the tendency to seek out information that supports our existing beliefs, while steering clear of anything that might challenge them. It’s comfortable—safe, even—to stay within the bounds of what we “know” to be true. Admitting we might be wrong can be uncomfortable (and for some, unimaginable), so we seek familiar, affirming information to avoid that discomfort. However, this habit of clinging to preconceived notions, rather than exploring new perspectives, can keep us financially stagnant and disconnected from opportunities.
Suppose someone is convinced that debit cards are the only responsible way to manage daily expenses, believing that credit cards always lead to debt. They only seek out advice that warns against credit card use, ignoring information on how responsible credit card use can help build credit, offer fraud protection, and provide rewards. As a result, they stick solely to their debit card, even in situations where a credit card might offer better security or benefits.
Red Flag: “Credit cards are dangerous; I’ll never use one.”
This approach might prevent them from building a credit history, limiting their options for future financing, such as a mortgage or car loan, or missing out on rewards and protections.
How to Counteract Confirmation Bias:
Use Data as a Guide: Rely on facts and data to validate decisions instead of personal preferences alone. Regularly revisit financial goals to see if any updates might help broaden your approach.
Behavioral Bias #3: Herd Mentality
Herd mentality is the tendency to follow the crowd, instinctively assuming that if everyone else is doing something, it must be the right choice. This social influence can be powerful, often pushing us to make quick decisions without fully evaluating them. In financial decisions, herd mentality might lead us to jump on the latest trend, believing that if others are succeeding, we will too—yet this can sometimes be misleading and risky.2
Example: Let’s say you notice that most of your friends and colleagues have leased new cars. Wanting to keep up, you lease a car too, even though buying a used car would align better with your financial priorities. You make the choice based on what you perceive as “normal” without fully considering the long-term costs.
Red Flag: “Everyone else is doing it, so it must be a good idea.”
How to Counteract Herd Mentality:
Pause and Reflect: Before making any decisions, take a step back and ask yourself if this choice genuinely aligns with your own financial goals.
Behavioral Bias #4: Overconfidence
Confidence in our knowledge and abilities, especially in finance, is empowering and often well-earned. It drives us to set ambitious goals and pursue growth with optimism. But there’s a fine line between confidence and overconfidence. When self-assurance crosses into a lack of respect for what we might not know, it can lead to decisions made with undue haste or a false sense of control. In these moments, we may overlook potential risks or fail to consider new information, which could affect our goals.
For instance, you might underestimate the resources, time, or market conditions needed to achieve certain financial milestones because you’ve successfully navigated similar situations before. Relying on past successes, you may approach the decision expecting favorable outcomes without thoroughly weighing all relevant, current data or assessing new variables.
Red Flag: “I’ve done this before…”
If you find yourself assuming a positive outcome based solely on past experiences, it may be overconfidence clouding your judgment.
How to Keep Overconfidence in Check:
Assess Each Situation Anew: Remind yourself that every financial decision is unique. Treat each goal with fresh scrutiny, acknowledging the possibility of unknowns.
Behavioral Bias #5: Anchoring
Anchoring bias occurs when we place excessive weight on the first piece of information we encounter when making a decision. This initial information, whether it’s relevant or not, becomes our “anchor,” guiding how we evaluate all other data. While it may feel natural to rely on that first impression, anchoring might limit our ability to objectively assess new information, potentially leading to suboptimal financial choices.3
Example: Imagine setting a budget based on last year’s expenses and “anchoring” to those numbers, without accounting for recent inflation or changes in your spending habits. Anchoring to outdated information may result in an unrealistic budget, making it harder to reach financial goals.
Red Flag: “This seems right because it’s what I started with…”
How to Counteract Anchoring Bias:
Pause Before Deciding: Allow time between gathering information and making a final decision to ensure that your initial impression doesn’t overshadow new insights.
Have you recognized any of these biases in your own decisions?
Or perhaps found yourself surprised by the ways they can subtly influence your choices?
The truth is, none of us are immune to biases, and even the best intentions can sometimes lead us astray. Logic often takes a back seat when emotions and ingrained thought patterns take the wheel, overshadowing facts and objectivity. But we don’t have to let biases have control over our financial choices.
Instead of surrendering to these impulses, we can adapt by taking small, conscious steps toward greater awareness. It starts with recognizing our biases and understanding how they influence our financial mindset. This awareness lays the foundation for making more deliberate, thoughtful decisions.
Source:
1. https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/loss-aversion/
2. https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/herd-mentality-bias/
3. https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/anchoring-bias/
Investment Advisory Services offered through Trek Financial LLC., an (SEC) Registered Investment Advisor.
Information presented is for educational purposes only. It should not be considered specific investment advice, does not take into consideration your specific situation, and does not intend to make an offer or solicitation for the sale or purchase of any securities or investment strategies. Investments involve risk and are not guaranteed, and past performance is no guarantee of future results. For specific tax advice on any strategy, consult with a qualified tax professional before implementing any strategy discussed herein. Trek 24-357
