Psychology in Financial Planning

The biggest challenge to developing a plan for your stock-based compensation is likely yourself!

Pre-Read: Key Questions This Article Answers

• What are the most common mental biases tech workers have when it comes to their company equity?

• What are the underlying reasons tech workers frequently make mistakes when developing a plan for their stock-based comp?

• How does behavioral finance and psychology impact decision making when creating a financial plan and/or stock-comp plan?

Your Biases Are Very Likely Clouding Your Decision Making

Behavioral finance is a well established branch on the proverbial academic tree. It delves into the cognitive biases and emotional shortcuts each of us make almost every day, wherein fear, greed, temporary happiness (i.e. a dopamine spike), mental heuristics, and "rules of thumb" drive a lot of our decision making -> frequently at expense of rational logic and data, leading to less-than-ideal outcomes.

For Stock Comp Decisioning, Behavioral Finance May Be the Most Important Thing to Understand

The above statement may sound like a bold one; but in our experience of working with clients, we stand by it 100%. At 30-40 Wealth, we frequently focus a lot of our time with clients on a number of behavioral finance concepts; for example we discuss regret minimization with nearly every one of our clients.

This is because stock comp is unique in a number of ways; as is working in the tech industry (especially at a pre-IPO companies seeking product-market fit, or in hypergrowth). These unique dynamics and perspectives can position individuals to make far more money at an earlier age than most, but also bias our decisioning in a number of ways.

Hundreds of books have been written on behavioral finance; and we won't try to (poorly) create a another here. But given how important behavioral finance is to your decision making, we've detailed below some of the key biases we see with technology professionals (with the hopes that you can recognize some of these in yourself, aiding you to improve your decision making):

The Anchoring Effect

Definition	Impact on Stock Comp Decisioning
The anchoring effect is a cognitive bias where people rely too heavily on an initial piece of information when making decisions. This "anchor" shapes their judgement, leading to overconfidence that the initial value is correct. As a result, adjustments away from the anchor are often insufficient, as people fail to account for new information rationally.	For stock-comp decisioning, the anchoring effect frequently comes into play when individuals think about the future value of their company as an investment. If the value of the company has 10x'd in the past, and the company is still growing, it must still be a great investment moving forward.

The Endowment Effect

Definition	Impact on Stock Comp Decisioning
The endowment effect is a behavioral bias where people value an item more highly once they own it. This occurs because ownership creates an attachment that increases the item's perceived worth, and people will refuse selling for an amount they would have readily paid to acquire it initially.	For stock-comp decisioning, the endowment effect is seen in multiple areas, such as early employees over-valuing their company stock because they helped build/create the firm. Or perhaps most commonly with vesting RSUs: wherein individuals who get a cash bonus would not buy company stock, but the same individual does not sell the vested RSUs (despite the two having an identical outcome)

Confirmation Bias

Definition	Impact on Stock Comp Decisioning
Confirmation bias is the tendency to search for, favor, interpret, and recall information that affirms one's prior beliefs or hypotheses. This biased approach to decision-making leads to drawing incorrect conclusions, as people fail to consider information (specifically, contradictory information) rationally.	For stock-comp decisioning, confirmation bias is sometimes seen when individuals are trying to determine the business prospects of their company. Their history and personal experience frequently bias their decisioning, resulting in an overly favorable/unfavorable opinion vs. what an unbiased third party would likely arrive at.

Relative Wealth Effect (i.e. "Keeping Up With The Jones'")

Definition

Impact on Stock Comp Decisioning

The relative wealth effect refers to the tendency of individuals to compare their own wealth and status to that of their peers, and to use this as a benchmark for their spending habits and lifestyle. This frequently leads to overspending and subpar financial decisions -> as people strive to match or exceed the perceived social status of their neighbors, colleagues, or friends (with decisions frequently motivated by jealousy, pride, or perceptions of social status, rather than objective financial logic).

For stock-comp decisioning, the relative wealth effect most frequently affects individuals' risk-taking appetite. In Silicon Valley, everyone knows at least 1-2 people (if not far more) who are decamillionaires via a big win from stock-based compensation. Some individuals desire to match their lifestyle results in taking much higher risk with their investments than they otherwise should be.

Proportional Reasoning Bias

Definition

Impact on Stock Comp Decisioning

Proportional reasoning bias refers to the tendency to make decisions based on percentages vs. absolute values. This bias leads to suboptimal financial decisions by overemphasizing relative size differences rather than absolute dollar amounts when evaluating options. A classic example is an individual finds a $40 item they want to buy, but are told the same item is on sale at a store 15 minutes away for $20 (50% off); most will make the trip (saving $20 for 15 minutes). But if a $500 item they want is available for $480 (4% off) at a store 15 minutes away most won't make the trip, even though the savings ($20 for 15 minutes) are identical.

For stock-comp decisioning, the proportional reasoning bias most frequently affects individuals with concentrated positions that need to be reduced/partially sold. They tend to think of the sales price in percentage differences from today's price (or a historical price) versus the dollar impact the sale will have on their life and financial plan.

You May Enjoy Reading "The Psychology of Money" by Morgan Housel

We don't frequently recommend books, but in our opinion one of the best personal finance books written in the last two decades is The Psychology of Money by Morgan Housel (and we're not alone; the book has sold over 4 million copies).

The book is a quick read, but powerful, in the concepts it details with helpful stories and anecdotes to illustrate key points along the way. For anyone who is seeking to better understand the "why" behind some of the financial decisions they make, and/or improve their financial decision making, this book is likely worth reading.

🔗 Link To Morgan Housel's Website

🔗 Link To The Book on Amazon (this is not a paid link; just simply provided for convenience)