Does “Behavioral Finance” Hold the Key to Your Entrapment Chamber Escape Hatch?

The field of research and thought labeled “behavioral finance” is exploding in importance and popularity, and the insights it is yielding offer a wealth of opportunity for each of us to learn about our own psychology and how it affects our ability to achieve financial independence.  The introduction to the behavioral finance discipline at Investopedia provides:

Much of what I read today in the news cycle related to behavioral finance tends to focus on the application of the discipline to understanding investing behaviors—an issue that is certainly fascinating in its own right—but I think the most compelling application of behavioral finance principles lies in other areas of personal finance.  The blocking and tackling of buying freedom:  spending less than you earn and investing every dollar of delta.  The concepts of the “anchoring effect” on perceptions of stock values, of confirmation bias on investment decisions, and of herd mentality on market movements are all quite useful and interesting, but the application of these cognitive biases to issues of spending, saving, and consuming is where maximum impact on freedom can be realized.  I’m tempted to argue that these principles of behavioral finance theory are the whole shooting match for our purposes here.  What better way to explain the irrational decision-making and cognitive dissonance that is exemplified by Working Joe who unwittingly trades his personal liberty for a Range Rover and a deluxe cable package?  As I explore some of these psychological constructs like the anchoring effect, mental accounting, confirmation bias, gambler’s fallacy, prospect theory, and of course—our favorite—herd mentality, I can’t help but conclude that we could all improve our situation (financial and otherwise) by better understanding how we are adversely impacted by their operation.

The Anchoring Effect

The classic example of the “anchoring effect” as applied to spending behavior is the “diamond anchor” idea that asserts that the “appropriate” amount to spend on a diamond engagement ring is two months of salary.  In an area such as buying diamond rings—where most of us have little to no experience—the anchoring effect can have a particularly large impact on our perception of how to proceed because it may be the only benchmark we have in order to shape our decisions.  But in reality the diamond-anchor amount has no basis in sound economic or personal finance theory, and was simply a construct created and spread by the very industry that stood to benefit from the anchoring effect when each of us accepted that we should spend something close to one sixth of our annual income on a shiny piece of jewelry.  Some may assert that this particular “anchor” isn’t far from a reasonable spending target.  But as a first-year attorney at a large corporate law firm making a good salary of $100,000 at the time I bought Mrs. JF’s shiny pledge token, the “accepted” benchmark would have politely suggested that I spend nearly $17,000.  I’m happy to report that I was not unduly persuaded by the “diamond anchor.”

A more extreme and instructive scenario that exhibits the potential impact of the anchoring effect was a research study where participants would spin a wheel that contained the numbers 1 through 100, and after seeing the result of the spin would be asked what percentage of the United Nations membership was comprised of African nations.  The study showed that the perfectly random result of the spin of the wheel had a dramatic effect on the answer given to the wholly unrelated question posed.  The number resulting from the spin of the wheel tended to anchor the responses to the UN question to a percentage that was in the ballpark of the number resulting from the spin.

Similar to the operation of the anchoring effect in the context of perception of true value of a stock—for example, when you buy Microsoft at $100 that will anchor your perception of its “proper” value—our lifestyle choices tend to have an anchoring effect on our psychology.  Once you have lived with the cleaning service, the unlimited cell phone plan, the 200-plus channel cable package, and the BMW, you inevitably tend to view this lifestyle standard as the baseline that you cannot go below.  Thus the only direction to go is up in terms of lifestyle cost, which equals upward lifestyle creep, which equals trapped in work.

Proposed antidotes to the anchoring effect cognitive bias: The ideal would be to avoid the anchoring effect at a lofty lifestyle level by not ratcheting up your lifestyle in the first instance.  If it is too late for that, seek out independent and fresh sources of thought and perspective regarding lifestyle choices (say, for example, blogs detailing reduced lifestyle financial independence).  My reading of other blogs over the years like MMM’s that advocate the logic, sanity, and beauty of a modest lifestyle helped me to overcome the psychological hurdle of leaving behind a number of costly indulgent lifestyle choices (such as the deluxe cable package) in large part on the basis of a realization that these amenities are not a component of a baseline lifestyle level necessary for contentment and happiness.

Mental Accounting

The concept here is that we have a tendency to put our money into different “jars” in our brains based on the source of or purpose for the money (or both).  If the money is from a source that creates a sense that it was “free” or found—say for example a tax refund—our mental accounting bias may lead to the conclusion that this money can be spent with reckless abandon.  If the money is earmarked for a special purpose such as a vacation or home improvement, our mental accounting might lead to keeping cash in the savings jar earning 0% interest even though you have consumer debt racking up interest at 18%.

Proposed antidote:  Understand that money is fungible and should be subject to the same principles regarding saving and spending regardless of its source or purpose.  If you generally employ a principle of never spending your money wastefully, apply this principle consistently to tax refunds (often erroneously considered “found money”) as well as your paycheck dollars.  Understand that dollars are fungible and interest rate arbitrage can be your friend or your enemy.  Not paying off your mortgage that costs you 2.5% (after tax effect) so you can invest in the market with the reasonable expectation of earning 3x that amount makes sense; saving cash for a future home improvement project at or near 0% while carrying a credit card balance at 18% does not.

Confirmation Bias

The confirmation bias effect posits that we tend to seek out information that supports a pre-existing worldview that we hold, while minimizing or ignoring contrary or adverse information regarding that worldview.  If you are a Working Joe that just bought a new BMW on credit thereby locking you in to your paycheck for the foreseeable future, you are much more likely to pay attention to the commercial on TV showing the shiny vehicle racing around curves and telling you that “you’ve earned it” than you are to read Joe Freedom’s blog explaining to you that you’re a (financial) idiot.  By focusing on favorable information that supports your hyper-consumption lifestyle rather than information that might contradict the wisdom of your approach, you avoid ever having to think too critically about your decisions.  You can cruise right along in a state of entrapped ignorance.

Proposed antidote:  When you are ready to take a hard, objective, realistic look at you financial situation and assess whether it’s really how you want to spend your life you should seek out opposing viewpoints and critically assess your path with the benefit of different and competing perspectives.  Once I did this it became clear to me I was on the wrong path by not moving more quickly and with great urgency toward financial independence.

Gambler’s Fallacy

The gambler’s fallacy construct posits that our minds can at times draw inferences regarding the probability of future events based on completely unrelated historical events.  The roulette wheel has landed on black six times in a row, surely red is next.  Of course the probability of the spin yielding red or black is the same for each and every turn, irrespective of what came before.  Here the application of this psychological construct to the specific field of investing is most instructive, as the research shows that it leads many individuals to make significant mistakes when it comes to investing their money (buying freedom).  The market has been going up for so long it’s bound to turn down!  I’ll wait!  Or its been headed down for so long it must be headed to zero … I’ll sell now!

Proposed antidote:  Making informed decisions regarding when to invest your money based on an intelligent assessment of current valuation levels is one thing, but making decisions on the basis of a general feeling created by market momentum or trend is not likely to yield favorable results.  If you are not willing or able to engage in reasoned analysis of market fundamentals to inform your investment decisions, then just put your money in the market in index funds as soon as possible and over the long-term it will work out.  In fact, even if you think you are able to engage in reasoned analysis of market fundamentals to inform your investment decisions, you may still just want to put your money in the market in index funds ASAP and forget about it.

Prospect Theory

Research shows that we feel more pain from losing $100 than we feel in pleasure when we gain $100.  This psychological phenomenon may explain why some are not able to make installment payments on their freedom by investing in the stock market—the fear of loss exceeds the optimism from prospect of gain—or why those who do invest often sell their winners too early out of fear of losing the gains.

Proposed antidote:  Understand this part of your psychology and overcome it with facts and logic.  Over the long-haul the stock market goes up.  Period.  Paper losses will be encountered along the way.  Ignore them, and for goodness sake do not lock them in by selling on the dips.

Self-attribution bias

This describes our tendency to attribute our successes to our own efforts and merits, but to explain away our failures as attributable to someone or something else.  That bonus I got, well, that’s because of my hard work.  I earned it.  But that pile of credit card debt … that’s attributable to circumstances beyond my control.  Nothing I could do.

Proposed antidote:  Take responsibility and ownership of your financial failures as well as your successes.  If you want to take control of your spending and budget—and thereby ultimately your liberty—you will have to own your shortcomings with respect to your finances.  You can’t fix a problem until you acknowledge that one exists.

Familiarity bias

Many of us focus on options that are familiar while shying away from those that are foreign.  Moreover, you can’t even consider or evaluate options that are simply unknown to be options.

Antidote:  Familiarity breeds acceptance.  The FI community is doing a public service by working to promote that familiarity.  This leads us to our favorite topic covered here.  The herd mentality.

Herd Mentality

I saved the best for last.  Of all the cognitive biases and psychological constructs discussed as part of the behavioral finance discipline, this one surely has done more damage to personal balance sheets than any other.  It’s human nature to look around at the herd and find comfort and security in behaving just like everyone else.  Work and spend, work and spend, work and spend … retire for a bit … then die.  The herd mentality bias is again particularly prevalent in any situation where you don’t have a lot of personal experience with the subject matter, and most of us do not have a lot of real experience with money when first starting out in our careers.  The herd mentality can also wreak financial havoc when you live in an affluent area like we do (see consumption challenges) and hyper-consumption is the norm.  Social media makes it worse—much worse.

Proposed antidote:  Once again it seems to me that the key to successfully combatting this cognitive bias is to expose yourself to radically different perspectives regarding spending and saving.  During my entrapment years, I always knew that in concept I was saving for a day when my investments (rather than a paycheck) would support my lifestyle, but it wasn’t until I immersed myself in the universe of financial independence blogs that I saw other people actually doing it—actually living this way—that I realized that this was more than a theoretical exercise.  It could be done in practice.  Being able to see this in real life made all the difference for me; it took what was something that I could conceive of in my mind—almost like a fantasy—and made it real.  In the absence of seeing someone else actually climb the mountain, many Working Joes will simply continue to run with the herd of hyper-consumers.  I hope that TIW along with the other FI blogs discussed here can serve as an alternative herd to follow by providing real-time, real-life examples of people that think differently and escape a lifetime of indentured servitude by buying freedom, not stuff.