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.

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

2. 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.
www.phroogal.com
@phroogal

3. 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.
www.phroogal.com
@phroogal

4. What is Behavioral Finance?
• 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.
www.phroogal.com
@phroogal

5. Are you rational with
money?

6. We’re NOT rational
with money.

7. 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.
www.phroogal.com
@phroogal

8. Behavioral Finance
1. Anchoring
2. Mental Accounting
3. Confirmation and Hindsight Bias
4. Gambler’s Fallacy
5. Herd Behavior
6. Over Confidence
7. Overreaction and Availability Bias
8. Prospect Theory
www.phroogal.com
@phroogal

9. Anchoring
1. Anchoring
• Attaching our thoughts to reference points
that have no logical relevance to decision at
hand.
– Diamond Engagement Ring
– Stock Valuations
www.phroogal.com
@phroogal

10. 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”
www.phroogal.com
@phroogal

11. 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.
www.phroogal.com
@phroogal

12. 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.
www.phroogal.com
@phroogal

13. 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.
www.phroogal.com
@phroogal

14. 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.
www.phroogal.com
@phroogal

15. 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.
www.phroogal.com
@phroogal

16. Pick One
1. 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.

17. Pick One
2. 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.

18. 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.

19. 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.
www.phroogal.com
@phroogal

20. 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.
www.phroogal.com
@phroogal

21. Learn more about at
www.phroogal.com