• Behavioral finance biases can influence our judgment about how we spend our money and invest.
  • Common pitfalls include mental accounting errors, regret aversion, and herd behavior.
  • Understanding these biases can help you overcome them and make better financial decisions.

Many investors believe in a theory called Efficient Market Hypothesis. It states that share prices reflect all information and stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices.

However, the market is made up of people, and of course, humans make mistakes, which makes the market inefficient, especially, the crypto market.

Regardless of how disciplined, people often make financial decisions that are colored by behavioral biases that cause them to act on emotion or make mistakes processing information. This is the basis for behavioral finance, a field of study that combines psychological theory with conventional financial economics. Behavioral finance predicts actual trading behavior based on these factors and is used as grounds for crafting more efficient trading strategies that correct human limitations.

Behavioral finance researchers have discovered that there are many mental shortcuts we use when we're making complex decisions. These heuristics can bias our judgments and lead to making missteps with our money. Behavioral biases are unconscious beliefs that influence our decisions. And they can affect your money, too.

Here are five common cognitive biases that can affect your relationship with money — and what you can do to overcome them.

1. Mental accounting

Mental accounting refers to the notion that people treat money differently depending on where it came from and what they think it should be used for.

The idea is that we separate our money into "mental accounts" for different uses, which influences our spending decisions. We guard some money cautiously when we mentally categorize it for a house but spend it liberally when it's "fun money".

That's why most people are keener to spend windfall gains on luxury items but would save that same money if they'd earned it. Earned money has been mentally allocated to an account, but the windfall money hasn't been.

Mental accounting can sometimes hurt you. For example, someone might choose to keep money in their savings bank account instead of paying off credit card debt. The money is already "accounted" for, or "dead money", which means they'd get stuck paying high interest on their credit card bills for carrying a balance each month while a portion of the money is just sitting around.

If they'd chosen to pay off their credit cards instead, they could use the money that would have otherwise gone to interest to instead rebuild their saving balance — or even use it to invest and build long-term wealth.

How to Avoid it: Create a budget to guide your financial decisions and better determine when to save versus spend money. And create a plan for how to spend windfall gains, like an inheritance or work bonus, ahead of time.

2. Regret Aversion

Regret aversion is when a person wastes time, energy, or money in order to avoid feeling regret over an initial decision that can exceed the value of the investment. One example is buying a bad car, then spending more money on repairs than the original cost of the car, rather than admit that a mistake was made and that you should have just bought a different car.

Investors do the same by not making trades, or else holding on to losers for too long for fear of regret. Having a basic understanding of behavioral finance, developing a strong portfolio plan, and understanding your risk tolerance and reasons for it can limit the probability of engaging in destructive regret avoidance behavior.

How to Avoid it: Don't leave it up to emotion. Create an investing strategy and stick to it. Accept your losses and find other opportunities.

3. Overconfidence bias

Overconfidence has two components: overconfidence in the quality of your information, and your ability to act on said information at the right time for maximum gain. Studies show that overconfident traders trade more frequently and fail to appropriately diversify their portfolios.

One study analyzed trades from 10,000 clients at a large discount brokerage firm. The study sought to ascertain if frequent trading led to higher returns.

After backing out tax-loss trades and others to meet liquidity needs, the study found that the purchased stocks underperformed the sold stocks by 5% over one year and 8.6% over two years. In other words, the more active the retail investor, the less money they make.

This study was replicated several times in multiple markets and the results were always the same. The authors concluded that traders are, "basically paying fees to lose money."

How to Avoid it: Trade less and invest more. Understand that by entering into trading activities you're trading against computers, institutional investors, and others around the world with better data and more experience than you. The odds are overwhelmingly in their favor. By increasing your time frame, mirroring indexes, and taking advantage of dividends, you will likely build wealth over time. Resist the urge to believe that your information and intuition are better than others in the market.

4. Anchoring bias

Anchoring is a phenomenon where someone values an initial piece of information too much to make subsequent judgments. In investing, this can influence decision-making regarding security, such as when to sell or buy an investment.

Since many investment decisions require multiple complex judgments, they're vulnerable to anchoring bias.

For example, a person may hold on to a stock longer than they should because they've "anchored" on the higher price than they bought it at. The buying price biases their judgments about the stock's true value.

How to Avoid it: Take time to do research and make a decision. A comprehensive assessment of an asset's price helps reduce anchoring bias. Finally, be open to new information — even if it doesn't necessarily align with what you've initially learned.

5. Herd behavior bias

Herd behavior happens when investors follow others rather than make their own decisions based on financial data (or FOMO). For example, if all your friends are investing in meme tokens, you might start too even though it's risky.

People follow the herd because it feels safer. There's also the "fear of missing out": If your colleagues are making money investing in a particular stock, it feels uncomfortable to sit on the sidelines.

Herd behavior can backfire. It can create massive bubbles like the Dutch tulip market bubble, the Dot-Com bubble, and even the real estate bubble of the mid-2000s ... and bubbles burst.

How to Avoid it: Step back and look at investments carefully: Delve into a project's fundamentals and see if it actually looks like a solid investment. And be skeptical of hot stocks promoted on internet forums.

Closing Thought

Do you see a bit of yourself in any of these biases? If you do, understand that the best way to avoid the pitfalls of human emotion is to have trading rules. Those might include selling if a stock drops a certain percentage, not buying a stock after it rises a certain percentage, and not selling a position until a certain amount of time has elapsed. You can't avoid all behavioral biases but you can minimize the effect on your trading activities.

Economists like to think we make financial decisions by maximizing returns and optimizing our outcomes. But the reality is that our decisions are influenced by a number of factors, including emotions and cognitive biases.

That can lead to financial errors. Being aware of them helps you avoid them. And having a financial plan to guide you is an important next step to making rational investment decisions.