Behavioral finance is the study of the effects of psychology on investors and financial markets. Sometimes people apply that term to practitioners like me who do interior financial planning and financial therapy. I’ve even been introduced as a “behavioral finance therapist.” This is not accurate; behavioral finance is very different from financial therapy.
One aspect of behavioral finance studies the cognitive biases that affect people’s investing and financial decisions. A few of these (which I’ve discussed in more detail elsewhere) are:
• Fear of Missing Out (FOMO): A sense of urgency, needing to join the crowd and take advantage of an investment or other opportunity before it’s too late.
• Confirmation Bias: Seeking out and relying only on information, whether from news media or advisors, which supports what we already believe.
• Anchoring: Comparing a current situation to a familiar past experience that does not apply.
• Monte Carlo Fallacy: Expecting something (like being dealt an ace in card game) to happen merely because it hasn’t happened recently. In reality, the odds of getting that ace are the same for each hand dealt, even if you have not had one in your hand for several games.
• Overconfidence Bias: Believing you have more knowledge or skill than you actually have, so you know for sure what is going to happen.
• Loss Aversion. Placing more emphasis on avoiding loss than the possibility of gain, which can result in being so fearful of risk that you don’t invest at all.
These and other cognitive biases definitely affect everything we do, including our relationships and our financial behavior. Learning more about them can be helpful. Yet that knowledge alone—understanding, “Oh, what’s going on here is loss aversion, or fear of missing out”—will not help you change financial behaviors that don’t serve you well.
This is where financial therapy comes in. It takes a deeper step of understanding and resolving someone’s personal history and trauma that is underneath the cognitive bias. We know that every investment decision we make that might seem illogical and irrational in terms of the impact on our financial wellbeing is always logical and rational when we look at the underlying beliefs. Financial therapy can help us explore our money scripts, the emotional traumas associated with them, and the protective intent of the seemingly illogical behaviors. It offers ways to process the emotional impulses coming from inner parts of ourselves that were traumatized and have been walled off and hidden away in our psyche. When we begin to embrace and be with those parts, we can acknowledge the emotion and set it aside. This helps us make financial decisions more consciously instead of automatically acting according to the biases we aren’t even aware that we have.
Check out The Financial Therapy Podcast by Rick Kahler concerning this topic.