- Don’t kid yourself. You are susceptible to psychological biases that muddy your money decisions.
- People with high levels of money biases are not as financially secure.
- Building systems for reducing your vulnerability to a few key biases can help you reach your money goals.
Book smarts will only get you so far in building financial security. Sure, grasping the importance of diversification, asset allocation and the ways compound interest can work for you (investing) and against you (carrying credit card debt) are essential money management skills.
But if you don’t pair financial literacy with a conscious plan to deal with the psychological forces that can undermine executing on book smarts, you’re going to have a harder time reaching your goals.
And let’s get one thing straight: you’ve got some biases lurking.
Researchers at Morningstar surveyed more than 1,200 individuals and found that 98% were prone to suffer from at least one of four behavioral biases that are known to cause us to make suboptimal decisions with our money. That is in line with other research.
“Everybody has some level of biases. You. Me. Advisors. All of us are susceptible,” says Sagneet Kaur, associate director of behavioral research at Morningstar, and co-author of the study The Financial Impact of Behavioral Biases.
Morningstar found that people with higher levels of a bias are more “financially vulnerable” than people with a lower level of that same bias.
Even the survey participants who scored high on financial literacy were impacted, suggesting financial book smarts isn’t any sort of magic shield.
But there’s plenty you can do to reduce the heat of behavioral biases in your financial life.
Be on high alert for damaging biases
There are more than a dozen types of behavioral biases that can impact your finances. Morningstar focused on four that its study participants were most susceptible to.
Present bias: We prefer to spend a dollar today on something that feels good/right (dinner out!) than saving that dollar for a future need, such as retirement that can be decades away.
Base rate neglect: A mouthful to be sure. This boils down to failing to take in the probability/likelihood that something will actually happen. The current bear market can foster feelings that your stock portfolio is doomed and you should sell. But if you do that you’re neglecting some important fundamental (base rate) facts: stocks over the long term are your best inflation hedge, and that selling during bear markets is typically a costly mistake.
Overconfidence: We tell ourselves we know what’s best. One manifestation of overconfidence is that it leads to trading stocks more and studies show the more we trade, the worse we do.
Loss aversion. The psychological pain of a loss packs about double the intensity of pleasure we feel from a gain. “When we have a loss it can make it hard to admit we made a mistake,” says Pamela Sams, president of Jackson Sams Wealth Strategies in Herndon, Va. “So we tell ourselves we’ll just wait for an investment to bounce back, when the smarter move may be to sell and reinvest in something with better fundamentals.”
Getting a bias under control can pay off
Morningstar asked participants questions to gauge if they had a low, medium or high level of these four biases. They also calculated each participant’s FinHealth Score, which is a widely-used measurement that takes saving, borrowing and planning habits into account to ascertain a person’s level of financial security.
They found that people with a high bias level were more likely to be financially vulnerable with lower levels of income and savings and higher levels of debt.
People with a high dose of overconfidence were 2.2 times more likely to be financially vulnerable than people with a low level of overconfidence bias.
People with a high level of present bias were 2x more likely to be financially vulnerable than those with a low present bias.
People with a high level of base rate neglect were 1.75x more likely to be financially vulnerable.
People with high loss aversion were 1.33x more likely to be financially vulnerable.
You get the picture: The more we’re held captive by a given bias the more likely it seems that we’re going to struggle with building financial security.
How to turn down the heat on behavioral biases
Check in on your older self. Sams suggests “projecting a bit” into your future as a way to push yourself to overcome present bias. For example, ask yourself: “Is 53 year old Pamela making choices that will serve 73 year old Pamela?”
Researchers found that when 20-somethings were shown an aged avatar of themselves they became more willing to save more for retirement. Wanna give that a whirl? There’s an Aging Booth app for that.
Morningstar’s Kaur suggests a Pinterest approach might be helpful.
“Create a vision board of things you imagine your future self wants,” she says. And add in a bucket list of what you want to have, and be able to do down the line. Check these visual prompts often, as a way to push yourself to make choices today so you can reach those goals.
Automate. Making automated periodic investments regardless of what is going on in the markets reduces the risk of overconfidence bias that can make you trade more. Bailing out of bad markets typically means missing the rebound.
Commit to a plan. Sams suggests that having an asset allocation strategy (your mix of stocks, bonds and cash) and then choosing diversified portfolios for your investments (mutual funds and exchange traded funds are the easiest ways to diversify) can address all sorts of biases. It keeps overconfidence at bay, in that you’re less likely to bet too much (or too little) on a given investment. It also can help tamp down present bias: when you have a plan to hold yourself to, it serves as a reminder of why (who!) you’re saving and investing for.
Slow down. A very persuasive part of our brain is hardwired to react in the moment based on a gut emotional response to whatever is in front of us. But when it comes to building financial security, it’s wise to tap into another part of our brain that is more deliberative and will more carefully run through the consequences of a decision.
The modern world can make it hard to avoid snap emotional decisions. The growing popularity of choosing a Buy Now Pay Later (BNPL)] option at online checkout can make it hard to ward off present bias. We see the chance to buy something with just a 25% down payment, and it induces us to make the purchase, and often, to buy more. Those are dollars that aren’t available to save.
Apps that make it super easy to access your account information, invest and get wrapped up in viral memes (hello, GameStop stock circa 2020) feed into base rate neglect and overconfidence. The decision to hold onto a losing stock just because it’s too painful to book the loss and move on (loss aversion) is another way we let our emotions get the best of our finances.
“You want to inoculate yourself by giving yourself time between when you make a decision and when you execute,” says Kaur. A cooling off period as it were. Leave the items in your online shopping cart for 24 hours. Delete the trading apps on your smartphone. Or at least push yourself to wait 24 hours before pushing the buy/sell button.
Slowing down and being more deliberative can also help with loss aversion. Take the time to honestly assess whether an investment remains a fundamentally smart choice. There is no investment that cares a hoot about what you paid for it; getting back to break even is a seriously flawed investment approach. Once you slow down and think through why you’re holding on to a losing investment, you may be able to push yourself to sell, and reinvest in something with better prospects. That’s likely to pay off in the long-term
Get professional help. While the core values of advice—diversification, asset allocation, debt management—are central to an advisor’s role, Vanguard research found that “behavioral coaching” was the single largest value-add an advisor brings to a client.
A financial advisor can be an effective antidote to all sorts of biases. A good pro is going to focus on an investment’s fundamentals, making it less likely you will fall victim to loss aversion. And having someone to provide guidance, and a good ear, should also reduce your susceptibility to base rate neglect and overconfidence, and will push you to save more today to ensure you have the future you want, which addresses present bias.
The Garrett Planning Network and the XYPlanning Network have searchable online databases of pros you can hire on a project or fixed-fee ongoing basis. They can help you create a financial strategy that navigates around damaging behavioral biases, or become an active partner in helping you turn down the heat of biases in your financial life..