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When you think of the subject “Behavioral Finance,” your mind might veer toward behavioral biases. You might think of herding behavior and the role it played in meme stocks and the chaos of Silicon Valley Bank’s demise. Or you may think of recency bias and how it contributed to people losing money by cashing out at the market lows in 2008 or 2020.
Behavioral biases are an important part of behavioral finance, but they are far from the sole focus of the subject. Instead, behavioral finance is the study of how real people make real decisions about their money in real environments, all of which are imperfect.
What Does It Mean to Make a Rational Financial Decision?
In short, it’s complicated.
One might think the most rational financial decision is the one that maximizes a person’s profits, but that may not always be the case.
In the literature on the topic, there are competing views on what makes a rational choice, with some models only focusing on maximizing a person’s expected utility, others incorporating the influence of social preferences and reference points, and others considering our inherent limitations when making decisions. What this all comes down to is that it’s not easy to denote what the most rational choice is, and it can depend on other things besides strictly objective matters.
Take, for example, a person’s decision to pay off student loans right out of college instead of investing for retirement. When looking at this decision from a dollars-and-cents perspective, this is an irrational choice—if the interest rate on the loan is below 7%, this person is losing money by not investing. However, let’s take a closer look at this scenario. Say this person is expecting to have to take time off work soon, thus needing to minimize short-term regular debt payments to make ends meet. Or, let’s say this person can’t sleep at night because of the weight of the student loans. In these cases, the most “rational” thing to do is pay the loans and postpone retirement savings.
Shortcuts Aren’t So Bad—It’s Biases You Need to Look Out For
Given the complexity of rationality, you can see how our minds have their work cut out for them. Making the “right” decision seems like trying to shoot a moving target. Here’s where the study of behavioral finance comes into play.
In our research, we explore how people grapple with financial decisions. For example, part of behavioral finance includes the study of heuristics—because we are dealing with so many decisions on a daily basis, all with their own layers of complexity, our minds take shortcuts, where we only consider some of the available information to make a decision. Most of these shortcuts actually work out very well for us, but some do lead us to the wrong conclusions and actions.
That’s when these shortcuts turn into biases—those well-known and discussed slipups of the human mind that now make up much of people’s interpretation of behavioral science.
What’s Next for Behavioral Finance
Learning about the shortcuts our minds take when making decisions is really only part of behavioral science. Instead, the field focuses more broadly on why people make the decisions they make and how we can positively influence their behavior.
In recent years, the field has doubled-down on making research findings practical and impactful. This increased scrutiny in the world of behavioral finance can be seen as a way of making this once-budding subject into a more rigorous field of study.
For financial advisors and investors, this is good news: It means more actionable insights one can use when making financial decisions.
