There are several behavioral heuristics and biases that can lead to poor financial decisions. For brevity, we will focus on a few; mental accounting, the endowment effect, loss aversion and status quo bias. For each bias, we will provide a definition and then provide examples of how the biases can lead to poor financial decisions. Mental accounting is the way individuals code and evaluate transactions, investments and other financial outcomes.
An example is when employees with access to company stock have 50 percent of company stock in their retirement plan and the remaining money split evenly between stock and bond funds. These employees make the mistake of owning too much company stock (not enough diversification). Mental accounting puts company stock into its own “asset class.”
The endowment effect, developed by Richard Thaler is the tendency to place more value on an object once an individual owns it; especially if it’s a good not regularly traded. Poor financial decisions arise when individuals hold on to losing stocks (or mutual funds) as the endowment effect places more value on these securities than they’re worth. An individual then holds onto an asset they should otherwise sell.
This same example can also explain loss aversion. In loss aversion, losses hurt more than gains feel good – about twice as much. This was a monumental discovery made by Daniel Kahneman and Amos Tversky and their famous “S” curve. In the prior example, the individual may hang onto the losing security since it hurts much more to realize that loss. For now, his losses are only “paper losses”. He can avoid the pain of losing by not selling. This of course, can be detrimental to his portfolio. In other words, due to loss aversion, individuals take more risk to avoid losses.
Status quo bias refers to the bias in favor of remaining in the current economic state. Poor financial decisions may arise from status quo bias where it’s in an investor’s best interest to switch companies and investment portfolios (due to high commissions and expense ratios) yet the individual remains with the poorer economic choice of the more expensive portfolio. Yet they know they should move.
Another example, in retirement savings plans, there is less participation for employees that have to “opt-in” versus plans requiring them to “opt-out.” In other words, more employees are likely to go with the status quo (that is, they are likely to stay with the option requiring the least amount of effort) in retirement plans that require “opt-in” versus “opt-out.”
There are many biases that affect the finances of individuals. These are just a few. By learning about these different biases individuals can have a better understanding of why they act the way they do regarding their financial decisions and whom to seek out to receive objective advice to resist the urge to give in to biases.