Behavioral Finance

Building wealth is not only about making smart investment decisions, it is also about understanding our own behavior and how it impacts our financial decisions. Even when we know what we should be doing, many of us struggle with making sound financial decisions. That's where behavioral finance comes in. Behavioral finance is a field of study that explores the psychological factors that influence financial decision-making. Understanding how our biases and emotions can impact our financial decisions is a key component of financial success.

Behavioral finance recognizes that humans are not always rational decision-makers when it comes to finances. We are influenced by emotions such as fear, greed, and overconfidence, which can cause us to make poor financial decisions. Even if we make all the correct investment decisions and follow all the best practices and first principles for wealth management, if we don't understand our own behaviors and tendencies, we may still make costly mistakes. Our success in investing will depend in part on our ability to realize that, at the heights of happiness and the depths of despair alike, "this too shall pass." In the end, how we behave is much more important than how our investments behave. Far more money has been lost by investors trying to anticipate corrections than lost in the corrections themselves.

Just like in fitness, behavioral finance is crucial to achieving success in wealth management. Financial fitness requires consistent effort and discipline in managing our money. Just as we need to maintain a healthy diet and exercise regularly to stay physically fit, we need to create and stick to a budget and savings plan to stay financially fit. Similarly, just as we need to avoid unhealthy habits like smoking or drinking to maintain physical health, we need to avoid financial behaviors that can lead to debt or financial instability, such as overspending or taking on too much debt. Many people struggle to stick to their financial goals, just like many people struggle to stick to a fitness routine.

We learn the most about ourselves when we fail. Failure is part of the process of success. People who avoid failure also avoid success; we cannot have success without failure. It is better for us to attempt to do something great and fail than to attempt to do nothing and succeed. The starting point of all achievement is fueled by our desire, our "why." We must constantly keep our eye on this vision, or we will lose sight of our goal. Weak desire brings weak results, just as a small fire produces a small amount of heat. This is where neuroplasticity comes into play.

Neuroplasticity is the brain's ability to change and adapt over time, rewiring itself in response to new experiences, behaviors, and thought patterns. It is a key concept in behavioral finance, as it means that we can rewire our brains to think and behave differently when it comes to finances. By identifying and addressing our financial biases, we can create new neural pathways and develop new habits and ways of thinking that are more conducive to financial success.

If we think of our brains as a dynamic, connected power grid, there are billions of pathways, or roads, lighting up every time we think, feel, or do something. Some of these roads are well travelled: these are our habits, our established ways of thinking, feeling, and doing. Every time we think in a certain way, practice a particular task, or feel a specific emotion, we strengthen this road and it becomes easier for our brains to travel this pathway.

When we think about something differently, learn a new task, or choose a different emotion, we start carving out a new road. If we keep travelling this road, our brains begin to use this pathway more, and this new way of thinking, feeling, or doing becomes second nature. As the old pathway gets used less and less, it begins to weaken. This process of rewiring our brains by forming new connections and weakening old ones is neuroplasticity in action. 

The good news is that we all have the ability to learn and change, by rewiring our brains. When we have changed a bad habit, or thought about something differently, we have carved a new pathway in our brains and experienced neuroplasticity. Just as our brains can change and adapt to new experiences and behaviors through neuroplasticity, we can train ourselves to develop better financial habits and behaviors through repeated and direct attention towards our desired change.

When we make a decision, our brain instantly starts comparing options, and neuroeconomics studies how our brain functions in economic and financial decision-making. Money is a primary motivator that activates the same area of our brain as food and water, while paying for things activates the same area of our brain as physical pain. Our brains anticipate experiences, whether positive or negative, and the anticipation can be as enjoyable as the experience itself. Understanding how our brains make financial decisions is very useful for investments and wealth management.

When it comes to wealth management, the goal is not simply to maximize wealth. In reality, investors are often unwilling to take on excessive risk in exchange for a small chance at a big payout. This is because of the concept of diminishing marginal utility, which means that we tend to derive less happiness from each additional dollar earned.

To illustrate this concept, consider the following scenario: would you rather have a guaranteed annual income of $100,000 or take a 50% chance of earning $175,000 but also a 50% chance of earning only $25,000? The answer may depend on your personal preferences and tolerance for risk. 

Instead of focusing solely on wealth maximization, we should think about investing in terms of utility maximization. The challenge is that it is easy to quantify wealth maximization – what investments will get me the greatest ROI – but we cannot easily quantify utility maximization. For example, how can we measure the stress of living beyond our means or the emotional energy required to deal with financial volatility?

Ultimately, life is too short to worry solely about money. We should instead focus on what we want to do with our lives and the experiences we want to have. For most people, their utility matters more to them than their investments do. They are interested in their investments only to the extent that they can help them achieve their life goals. Investments are similar to insurance in that they allow people to transfer wealth between potential future outcomes. Risk-averse investors prefer consistent payouts from their investments to payouts that could either be very high or very low. For an investor to accept the possibility of investment risk, they must be compensated with a higher expected wealth from taking that risk.

One of the key utilities of money in behavioral finance is as a store of value. Money allows us to save and accumulate wealth over time, providing a sense of security and stability. However, behavioral biases can impact our ability to save and invest wisely. For example, the endowment effect is the tendency to overvalue assets we already possess, leading us to hold onto assets that may not be the best investment for our financial goals.

Money also serves as a unit of account, providing a way to measure and compare the value of goods and services. However, our perceptions of value can be influenced by psychological biases such as anchoring, where we rely too heavily on the first piece of information we receive when making a decision.

Lastly, money serves as a medium of exchange, allowing us to transact for goods and services. However, our decisions around spending and consumption can be influenced by behavioral biases such as the status quo bias, where we default to the familiar rather than exploring new options. 

Humans strive to create a circle of safety around themselves to avoid stress and threat. When we feel tense or uncertain, our bodies release the chemical cortisol to help stabilize us. Inside our circle of safety, we feel secure and happy, but outside it, we see only danger. This is why many people fear investing their money: they believe it is outside their circle of competence and see only risk and potential loss. Our sense of belonging also contributes to our happiness, as our brains require two root conditions for optimal performance: social interaction and feeling valued by others. The more valued we feel by those around us, the safer we feel, and our brains interpret this as increasing our chances of survival.

Insider bias is a common human trait that favors insiders over outsiders, which can be particularly damaging in investing. Studies show that insider bias affects our mental state, which is as critical to investors. Our mental state plays a significant role in our success, and when we are stressed, the brain consumes much more energy to operate, which can compromise speed and accuracy. This is why high-risk strategies tend to have lower levels of performance long-term.

Feeling like an outsider can activate the dorsal anterior cingulate cortex (dACC) and the right ventral prefrontal cortex (RVPC), the same areas that activate when a person experiences risk, fear, and physical pain. Pain is the top priority for our brains, and when we are experiencing pain, our brains focus all their energy on eliminating it. If we are thinking or analyzing something, but there is underlying pain, our brains will prioritize eliminating the pain over the task at hand. The brain works in terms of ROI, so it prefers to remain close-minded unless there is a good reason to be open. 

Let's take budgeting as an example. As consumers, we naturally prefer immediate comforts over long-term financial planning. Budgeting may make people cringe because it is often associated with restraint, but it is one of the most effective ways to ensure the protection and growth of our future wealth. The scales of a budget are balanced between income and expenses.

The budgeting question that we get most often is: how can we save 10% of our income when 100% is not enough to cover our necessary expenses?! We have helped many families with their finances, and at the start of their journeys, many found themselves with no money left at the end of each month. Regardless of their income level, be it lower-class, or upper-class, the accounts were equally empty.

The root cause of this symptom is a lack of proper budgeting. The principle of Parkinson's law applies to money and time, meaning our necessary expenses will always grow to equal our incomes unless we actively protest otherwise. It is crucial to differentiate between our desires and necessary expenses. We all have more desires than our incomes can gratify, just as weeds grow in a field where the farmer leaves room for their roots, desires grow in our hearts whenever there is a possibility of gratifying them. 

A budget allows us to examine our living habits and identify expenses that can be reduced or eliminated without substantially reducing our happiness. Our budget acts as the general leading the army to defend our fortress of wealth against the siege of expenses. Winning this battle is challenging because we need to rewire our brains to view budgets, expenses, and incomes differently from how we are naturally inclined and how we were taught to think about them. It is natural to say, "I work hard for my income, and I have the right to enjoy the good things in life. I rebel against the restraints of a budget that determines how much I may spend and for what, because it would take pleasure away from my life."

However, we must remember that we are the ones constructing our budget, based on our unique situations and goals. The purpose of a budget is to create wealth, ensuring that we have enough money to pay for our necessities, enjoyments, and long-term goals without overspending. A budget defends our most cherished desires from our casual wishes, shining a light on the leaks from our savings and helping us control our expenses for specific and gratifying purposes. By protecting ourselves from unnecessary expenses and investment stress, we can stay the course and build resilient generational wealth.