Personal Finance: Introduction to Behavioral Finance by @Phroogal

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Jason Vitug @jasonvitug Introduction to Personal Finance Behavioral Finance Theory: Why We Make Irrational Financial Decisions

description

Behavioral finance is a subcategory of finance that seeks to explain the rationality or irrationality of financial decision-making. It seeks to combine behavioral and cognitive psychology theory with finance to provide explanations for why people make irrational decisions.

Transcript of Personal Finance: Introduction to Behavioral Finance by @Phroogal

Page 1: Personal Finance: Introduction to Behavioral Finance by @Phroogal

Jason Vitug@jasonvitug

Introduction to Personal FinanceBehavioral Finance Theory: Why We Make Irrational Financial Decisions

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Introduction

• The plan is to introduce behavioral finance theory.

• The goal is for you to understand how our decision making is impacted by psychological behaviors.

• The takeaway is to know important concepts and become more aware of our financial decision making process.

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What is Personal Finance?

• Personal finance is the use of financial management principles with respect to individual or family unit finances to manage money, budget, save and spend while taking into account various future risks and life events.

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What is Behavioral Finance?

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• Behavioral finance is a subcategory of finance that seeks to explain the rationality or irrationality of financial decision-making. It seeks to combine behavioral and cognitive psychology theory with finance to provide explanations for why people make irrational decisions.

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Are you rational with money?

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We’re NOT rational with money.

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Irrationality with Money

• We all want to be wealthy and increase our well-being.

• We understand that we shouldn’t spend money we don’t have.

But…• Emotion and psychology influence our

financial behaviors in unpredictable and irrational ways.

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Behavioral Finance

1. Anchoring2. Mental Accounting3. Confirmation and Hindsight Bias4. Gambler’s Fallacy5. Herd Behavior6. Over Confidence7. Overreaction and Availability Bias8. Prospect Theory

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Anchoring

1. Anchoring• Attaching our thoughts to reference points

that have no logical relevance to decision at hand.– Diamond Engagement Ring– Stock Valuations

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Mental Accounting

2. Mental Accounting• A tendency to separate money based on

subjective criteria often impacting financial decisions and wellbeing.– Saving for vacation or home earning very little

interest yet continuing to pay high interest rates on existing debt.

– Causes people to not use money efficiently such as “found money”

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Confirmation and Hindsight Bias

3. Confirmation Bias• Selectively filter and pay more attention to

information that supports our opinion while ignoring any thing that may dispute it.

3. Hindsight Bias• Believing that the onset of past events were

predictable and completely obvious although outcome could not be predicted.

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Gambler’s Fallacy

4. Gambler’s Fallacy• Belief that because of a series of events the

likelihood of a random event will less likely occur.– Flipping a coin.

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Herd Behavior

5. Herd Behavior• Mimic the actions of a larger group whether

rational or irrational.• Social pressure of conformity.– Taking out student loans.– General acceptance of credit cards– Purchasing a home.

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Overconfidence

6. Overconfidence• Confidence implies realistic trust in one’s

ability while overconfidence usually implies optimistic assessment of one’s knowledge and control over a situation.

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Overreaction and Availability Bias

7. Overreaction and Availability Bias• We overreact to recent news and give more

weight to recent trends.– Purchasing stocks because of recent good news

causing price to skyrocket. Conversely, selling stock on bad news causing price to plummet.

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Pick One1. You have $1,000 and must

choose between A or B.---

Choose A) You have 50% chance of gaining $1,000, and a 50% chance of gaining $0.

Choose B) You have a 100% chance of gaining $500.

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Pick One2. You have $2,000 and must

choose between A or B.---

Choose A) You have 50% chance of losing$1,000, and a 50% chance of losing

$0.

Choose B) You have a 100% chance of losing$500.

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Majority of people will choose (B) for Question #1

and choose (A) for Question #2.

--------------The right answers are either A or B for both

questions. However, those choosing the answers above are more risk adverse.

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Prospect Theory

8. Prospect Theory• Value gains and losses differently. Feel more pain in

losing than joy felt in receiving equal amount of gain.• Given two equal choices, one expressed in gains and

the other in losses, people choose the gains although yielding the same economic result.– Choosing not to save in a bank or refusing to work

overtime.– Selling winning stocks and holding on to losing stocks.

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Is it okay to be irrational?

• By understanding your mindset and behaviors, you can set up systems to account for the irrationality of our financial decision-making process.

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