Behavioral finance is a type of finance that examines the psychological aspects about how we make decisions about money. This is part two where we will examine two more theories of behavioral finance and how it effects our financial decisions.

The first one is called “anchoring bias” and to better understand this theory, let's consider a few scenarios.

Why is it that when we buy a stock for $10, and then it goes to $7, we immediately think about selling once it goes back to $10?

Or, have you ever seen someone buy a piece of real estate for say, $500K, and then they put it up for sale at $525K. They get no buyers. They then lower the price but wont reduce their selling price below what they bought it for?

What is this phenomenon that occurs in our minds? When making decisions, we are all faced with some form of anchoring bias. We are influenced by our cost basis, an arbitrary price point, or some number we have in our mind. This number has no real bearing to anyone else, but it means a great deal to us.

What Can We Do?

• Be flexible and open to making new decisions.

• Just because a stock, mutual fund, or piece of real estate was at a certain value, doesn't mean that your investment will come back.

• Try not to place so much importance on one specific factor when making a decision.

The next one is called “mental accounting.” For this theory, ask yourself these questions:

How do you spend your tax refund money?
How do you spend money that you forgot someone owed you?
How do you spend money that you earned from working a 12 hour day?

The point is, we treat various sums of money differently based on where the money comes from. This is the world of mental accounting. When we're in this world, we forget that money is
fungible – that it’s interchangeable and can be used for different purposes, regardless of where it came from. In other words, we keep different buckets and sources of money in our mind for different purposes.

So how does this apply to investing?

Many of us invest for income and appreciation. We are more comfortable spending the interest off of our investments because we are not dipping into our principal. In our minds, we are taking money from the income bucket. It is harder to sell part of the principal of the account even if it has gone up because we feel we are cutting into the bones of our money.

We end up taking more risk to generate a higher amount of cash flow, without regard to how are principal will perform.

So, when making decisions about how you spend or invest your money, think of the bigger picture -- your financial plan -- regardless of where the money came from.

(This article is for informational purposes only and should not be construed as individualized investment advice.)

Author's Bio: 

Justin Krane, a CERTIFIED FINANCIAL PLANNER TM professional, is the founder of Krane Financial Solutions. Known for his simple, savvy, holistic approach to financial planning, he has the unique ability to advise his clients on how to merge their money with their lives, so that they can make sound decisions with their finances, and get more of what they want in their lives. Using a unique system developed from his studies of financial psychology, Justin partners with you to identify and clarify your goals, and advises you on what you need to do to reach them.

He holds a Bachelor of Arts degree in Finance from University of Colorado, Boulder, graduating in 1994. Prior to founding Krane Financial Solutions, Justin was a Vice President, Investments, and Sales Manager at UBS Financial Services Inc., for 12 years, in Beverly Hills, California. Justin has earned the designation of Certified Investment Management Analyst from the Executive Education Department at the Wharton School of Business. He is also a Member of the Financial Planning Association, the largest organization of professionals dedicated to championing the financial planning process.

He has two children and lives with his family in Calabasas, California. Justin is an accomplished athlete and was a former junior ranked tennis player in Los Angeles. He loves to cook, travel, speak Italian, and spend time with his family. Justin is also an active member in the Cystic Fibrosis Foundation.