What Is Behavioral Finance? A Complete Guide to Understanding Your Money Mind
We can sometimes be unaware of our feelings and emotions driving our financial decisions
TL;DR
What is behavioral finance, and how can it help me?
Behavioral finance combines psychology and economics to explain why we make money decisions that aren’t always logical. It shows how your feelings and mental shortcuts secretly steer your money choices—and understanding it helps you catch costly mistakes before they happen and make decisions that actually fit your goals and values.
Have you ever bought something you didn’t need… just because it was on sale? Maybe you saw a sale on a beautiful crusty loaf of artisan bread – $9 for one, $14 for two. You feel great because of the deal you got. And though you eat most of the first one, by the end of the week, the second one is a science project of mold. You forgot the bread from this bakery doesn't have preservatives. Now you've wasted $5. You might tell yourself to freeze it next time, but the money is already gone.
We're always looking for a good deal, trying to avoid a loss, or so afraid of making the wrong decision that we don't make a wise choice at all. This is where behavioral finance comes in—it helps explain why we make these money mistakes and how to fix them.
Behavioral finance teaches us that our financial choices are influenced by a lot of psychological factors and biases. We think we're being logical with money, but we're often motivated by fears and desires we don't acknowledge or identify. This is especially true when our behaviors are tied to desires or addictions like food, technology, shopping, or gambling. These activities can all trigger a release of brain chemicals and hormones that we crave, and our money is at the center of all those behaviors.
If you're ready to understand your money mind and take control, you're in the right place.
What Is Behavioral Finance?
Behavioral finance combines principles from psychology (the study of thinking and behavior) and economics (making wise money choices) to explain how and why people make financial decisions. It contrasts with the traditional view that individuals are always rational actors who make logical choices to maximize their wealth. Instead, it recognizes that human behavior is influenced by many different factors, emotions, and mental shortcuts, which lead to typical errors in financial judgment.
The human brain is always looking for shortcuts to conserve energy. While this helps us learn lessons and automate daily tasks, it can also lead us to learn the wrong financial lessons. Our brain's drive for efficiency helps explain phenomena like loss aversion, which is the powerful feeling that the pain of a loss is greater than the pleasure of an equivalent gain. This bias helps explain why we might hold on to losing stocks for too long, are overconfident in our skills, or follow the crowd during market bubbles.
Key Principles of Behavioral Finance
Loss Aversion
Example: You have a closet full of clothes you never wear, but you can't bring yourself to get rid of them. You know you paid a lot for them, and the thought of just giving them away feels like a big loss. This is similar to holding onto a losing stock or real estate investment for too long, just to avoid the psychological pain of accepting the loss.
How to spot it:
Notice if you're holding on to something you no longer use or want just because you don't want to accept that the money you spent on it is gone.
Ask yourself, "If I didn't already own this, would I buy it today?"
Overconfidence
Example: This is when we overestimate our own knowledge, skills, or ability to control outcomes. It can lead to taking on excessive financial risk or making decisions without proper research because we mistakenly believe we're better than average.
How to spot it:
Catch yourself using phrases like "I just know it" or "the experts don't know what they're talking about" when it comes to your financial decisions.
Reflect on your past predictions. Have you been right as often as you thought you would be?
Anchoring
Example: This bias involves basing decisions on irrelevant reference points. It's most frequently seen in marketing tactics, such as an "original price" for a purse being $300, and now it's $175. It's also seen in tiered pricing, where the top, premium model isn't expected to garner many buyers, but rather to point to the mid-priced model that's priced to make a profit but not be out of people's price points.
How to spot it:
Ask yourself if you are comparing a price to the first number you saw, rather than to the item's actual value or a realistic market price.
Look for other options before accepting the first offer in a negotiation.
Mental Accounting
Example: We categorize our money into different mental "buckets," such as "fun money" or "savings," which can cause us to treat it irrationally. This often leads us to spend a bonus or a gift of money more freely than we would our regular paycheck, even though all money is fundamentally the same.
How to spot it:
Ask yourself if the source of the money (e.g., a bonus, a gift, your regular paycheck) is influencing your willingness to spend it.
Notice if you are willing to go into debt for one item while you have a healthy savings account for another.
Confirmation Bias
Example: This is our tendency to seek out information that supports our existing beliefs while ignoring anything that contradicts them. This can reinforce a poor financial decision and prevent us from seeing the full picture. For example, people who believe they can profit by borrowing at 6% to invest at 11% will focus only on success stories while ignoring the significant risks, like a market downturn, that could lead to a massive loss.
How to spot it:
Pay attention to your media consumption. Are you only following people and sources that agree with your financial opinions?
Force yourself to read an article from a different perspective to see if your views hold up.
Behavioral Finance Examples in Everyday Life
Overspending during sales events: This is often an example of anchoring. The "sale price" is made to look good against the inflated "original price," leading you to spend more than you intended.
Holding losing investments for too long: This is a classic case of loss aversion. The pain of realizing a loss is so strong that we avoid selling, hoping the investment will eventually recover to its original value.
Splurging after a bad day (“retail therapy”): This isn't one of the core principles but is a common emotional decision. It's an irrational choice to use shopping as a way to cope with negative feelings, providing a short-term boost that often leads to buyer's remorse later.
Avoiding investing because it feels “too risky” after a market drop: This is another example of loss aversion. The recent and painful experience of a market drop makes a person overly cautious and risk-averse, even when it might be a good time to buy.
Taking financial advice only from people who agree with you: This is a clear demonstration of confirmation bias. You are seeking out information and opinions that reinforce your existing beliefs, rather than getting a balanced perspective that might challenge your assumptions.
Why Behavioral Finance Matters
For Individuals
You have control over your money and your life. When you understand yourself—your motivations, emotions, and how they impact your money—you can make better decisions, have fewer regrets, and align your behavior more closely with your goals.
For Couples or Relationships
Understanding the emotions and motivations behind money choices can drastically reduce money fights. This is an example I often use: my husband and I used to argue a lot about money at the start of our marriage. Once we found a budgeting app that truly worked with how we think about money, those fights dropped by at least 90%. Our marriage is exponentially happier because of it. Another benefit is that it improves communication on all topics, not just finances. When the emotion is taken out of financial decisions, it’s much easier to communicate thoughtfully and lovingly with one another about everything else.
For Businesses and Investors
When I teach business students in Psych 101, they often think the class is irrelevant to them. But as they progress, they realize that thinking, behavior, feelings, and motivations are all crucial to understanding their customers. This knowledge helps them serve customers better, making their lives easier or serving them a product they need.
How to Apply Behavioral Finance in Your Own Life
Build awareness of biases
Start by recognizing your own triggers and patterns. Acknowledging that you're not perfectly rational is the most important step. Naming your biases brings clear awareness, especially for beliefs you hold close. Identifying a bias doesn't mean your perspective is unimportant; it simply allows you to understand its influence.
Set up “guardrails”
Create systems that help you avoid common mistakes. This could mean setting up automatic transfers to a savings account to prevent impulsive spending, or using apps that limit how much you can spend on a credit card. For couples, agreeing to a minimum amount before making a purchase is also important, as it builds trust and accountability.
Use reflection tools
Tools like journaling can help you understand the emotions behind your financial decisions. Writing down your thoughts before a big purchase can give you the clarity you need to avoid a costly mistake.
Be Intentional
Take a moment to pause before making a money decision. Ask yourself if this choice aligns with your long-term goals or if it's an emotional response to a short-term, unpleasant feeling.
Common Myths About Behavioral Finance
"It's just for investors."
Nope. Big words don't necessarily mean that the principles underneath are unimportant. Behavioral finance is for everyone, because it has to do with your behavior with every dollar you spend or set aside—saving for retirement, buying groceries, or going on vacation. All of these fall under the sway of your emotions and biases.
"It's only pop psychology."
Wrong again. Psychology is the study of thinking and behavior, not Freudian slips. Behavioral Finance takes real-world principles, like supply and demand, and reveals how our very human feelings mess with them.
"It's too complicated to use in real life."
Not at all. You're already using your emotions to make money choices. Behavioral finance just gives you the words to name what you're doing. Once you can name the reason, bias, or feeling underneath the choice, you can learn to make better-informed decisions.
Final Thoughts
The biggest takeaway is this: understanding your (emotional) money mind leads to better choices. Your brain is wired a certain way, and knowing it will make you more intentional and move more powerfully toward the goals you truly want, like personal peace, harmonious relationships, contentment, and joy. The key is data to show you what and how: acknowledging your emotions, desires, and biases are the first steps toward taking control of your financial life and building a future you're excited about.
If you'd like to explore your own money habits and create a plan that fits your life, book a free introductory session today.
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