Psychology of Financial Planning

Chapter 11Behavioral Finance: Understanding Cognitive Biases and Heuristics … and What to Do About Them

Behavioral finance seeks to understand people's instincts regarding money and, at the risk of oversimplification, figure out why they tend to make poor financial decisions. It examines how normal human cognitive processes influence, explain, and predict individual and collective financial behaviors.

A cognitive bias is a systematic error in thinking that arises from our attempts to make sense of a complicated world. Many of these ways of thinking helped us survive and thrive throughout human history. However, in today's complex world, cognitive biases can result in errors in thinking, perception, memory, and attention. A heuristic is a process for doing something, in many cases defined as a rule of thumb that may or may not be ideal but is a readily accessible strategy to solve a problem or analyze a situation. A heuristic tends to be based on previous experiences.

While the thoughts, emotions, and behaviors of clients may vary widely, there are common cognitive biases and heuristics that inform human behavior when it comes to financial decision making. These biases are the result of genetic coding passed down from our ancient ancestors, inborn instincts, and how we, as human beings, perceive the world around us.

There are several steps a financial planner can take to mitigate these biases and help the client stay focused on their long‐ and short‐term goals. At the same time, ...