What is Behavioral Finance?

Behavioral finance is the study of the psychological factors, emotions and subconscious beliefs of investors and how they can affect decision-making. 

"Behavioral finance is the application of cognitive psychology to finance,” says Bradley Klontz, PsyD, CFP®, associate professor of practice in the Department of Economics and Finance at Creighton University. “Cognitive psychology examines how people acquire, process and store information, and it explores ways in which that affects emotions and behavior.”

Advisors now find themselves managing client behavior, and this is at the heart of behavioral finance.

“The relationship between advisor and client has become the most important aspect of financial planning,” says Klontz. “It's not about products. It's not about the investment portfolios. It's now the relationship that the advisor establishes with the client and the role they're playing in their client's life. 

“That role has now expanded beyond just selling products and managing portfolios."

Why is behavioral finance important?

Financial professionals use behavioral finance to help their clients identify and overcome certain psychological biases so they can make better financial decisions.

“If we understand what drives people to act irrationally in regard to their finances, experts can begin to build a framework to help people make better decisions—and that can help us better understand market behavior overall,” Klontz says.

“Understanding behavioral finance can help you better serve your clients,” he adds.

5 common psychological biases that affect investor decision-making

One of the key aspects that behavioral finance studies is the influence of psychological biases. Also known as cognitive biases, these are systematic errors in thinking that can sway our judgments and decision-making.

"All of these biases can be self-destructive in our current environment of modern finance,” Klontz says. “They can be explained by our prehistoric brain that was just trying to survive in a hunter-gatherer environment.

“It's only in recent times that we've even dealt with an abstract thing called money or investing. When we become emotionally charged, we become rationally challenged, and these biases kick in. We make these decisions from our emotional brain—which worked great in terms of our survival as a species—but it may not be as beneficial to us in our modern financial lives."

1. Loss aversion

Loss aversion is our natural tendency to avoid experiencing a real or perceived loss. This, in turn, affects how we make decisions relating to our finances.

"For example, with stocks, we have a disposition to hold on to losing stocks and sell winning stocks, which is the absolute opposite of what you should be doing,” Klontz says. “And part of that is because of our aversion to loss. If I have an investment that has tanked, selling it would mean admitting defeat. I would have to sit with the idea that I made a mistake. If I don't want to have that experience, I may hold onto it, even though it may be in my best interest to sell."

2. Familiarity bias

Familiarity bias is a cognitive bias that causes people to prefer familiar options over unfamiliar ones, even when the unfamiliar options may be better.

“The more familiar we are with something, the more likely we are to make bad decisions about it,” says Klontz. “It's part of our inherent cognitive laziness, and it's also related to safety and survival.

“Say you're looking at two potential food sources: one you’ve eaten for years and years, and one you've never seen before. That new food source might actually be healthier for you, but it's probably a good idea not to try it because it might kill you. So we have this natural tendency to prefer what’s familiar."

3. Herd instinct

Herd instinct (or herd mentality) refers to investors’ tendencies to follow what other investors are doing rather than their own research and analysis. 

"If everyone in your tribe got up and started sprinting south, it's a good idea for you to get up and start sprinting south,” Klontz says. “The people who didn't do that got picked off by a saber-toothed tiger."

A similar concept applies here.

“When we see people around us jumping into or out of a particular investment or asset class, it goes against our nature to sit still or do the opposite,” Klontz says. “The herd instinct helps explain every investment bubble and crash we have had throughout history.”

4. Overconfidence bias

Overconfidence bias is the tendency of investors to overestimate their knowledge and financial abilities. One of the key ways we see this bias play out is that, on average, women are better investors than men.

“And when we say better, we're talking as high as 1% annual return on average, which is huge,” Klontz says, referring to a pioneering study that examined gender and overconfidence.

“One of the reasons for this is that women may feel less confident in their ability to predict the right investments,” he says. “Men, in turn, tend to feel overconfident in their abilities, which causes them to trade more than women. By trading more, they hurt their performance.”

A study by Fidelity Investments confirms this. Based on an analysis of annual performance of 5.2 million accounts, the study found women investors tend to achieve positive returns and outperform men by 40 basis points.

5. Status quo bias

The status quo bias is people’s preference for things to stay as they are by sticking with a decision made previously.
“This is our desire to keep things the way they are,” Klontz says. “So even in situations in which we should take action, doing nothing is our natural default and can work against us.”

Behavioral finance and the CFP® certification

CERTIFIED FINANCIAL PLANNER® certification is considered the standard of excellence in financial planning. The CFP Board now lists “psychology of financial planning” as one of the eight principal knowledge domains covered in the CFP® certification exam.
“The fact that the CFP Board identified the psychology of financial planning as a formal knowledge topic to become a CERTIFIED FINANCIAL PLANNER® is indicative of how important behavioral finance has become,” Klontz says. 

Which roles use behavioral finance in their day-to-day functions?

Regardless of whether you go on to earn the CFP® certification or not, a solid knowledge of behavioral finance is needed for the following roles, according to Klontz: 

• Financial planners
• Financial advisors
• Financial coaches
• Behavioral finance directors
• Financial wellness coordinators/financial wellness managers
• Financial therapists

Gain a competitive edge with a master’s in financial planning and financial psychology

If you’re interested in behavioral finance and/or want to prepare to sit for the CFP® exam, earning an online Master's in Financial Planning and Financial Psychology may be a good idea. The Creighton University program is one of the few graduate business programs in the country with a heavy emphasis in financial psychology taught by leading experts in the field.

Ready to learn more? Request more information today—one of our Creighton University Student Success Managers will reach out.

Disclaimer: Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER®, and CFP® (with plaque design) in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.