Look around you. How many financially confident people do you know? How many can proudly say they didn’t make any financial mistakes and have always picked the right financial decision?
My guess is not too many.
We are all just human beings. Our brains are not computers able to take into account all the factors and calculate the precise outcome of any choice.
Sometimes, we make wrong decisions about our finances. Actually, a lot of bad decisions.
Let’s see how behavioral finance research can help you to better understand why we make mistakes and to improve our financial decision making process.
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What Is Money For You?
What is the right financial decision at all? It depends on the context, your experience, preferences and confidence. What is right for you is not right for everybody. What is right now might not be right later.
When you think about your financial life, ask yourself this simple question:
What is money? I know, it’s coins and banknotes, but what is money for you?
Write it down, please. We’ll come back to it soon.
Before we get back to money, let’s play a simple game:
Imagine that you are in the airplane flying above a dry, yellow, hot desert. Everything around is just dust and sand, except a mining town far away that you can see out of the window. Suddenly, the pilot announces that there is a problem with the engines and the plane is going down. So you end up alone, crashed in a hot desert. At least you are not injured, thank God.
The plane is going to explode and you must quickly choose only three items out of the following six:
- small cosmetic mirror
- “Edible Animals Of The Desert” book
- map of the area
What would you choose?
Write it down, so you can’t change it later. Don’t cheat on me!
Now, tell me – what is your strategy to get out of this nasty boiling-hot place? What is your plan for the next two-three hours?
Are you going to try to make it to that mining town you saw out of the window and find other humans? In this case, you’ll probably need water, the map and the compass.
Do you prefer to stay near the crash site and just wait to be found? Then water, parachute to cover from sun and mirror to signal can be very handy.
Do you see the point of this game?
Most human beings go to the objects, to picking the tools before they think about the strategy.
Money is not a strategy. Money is a tool.
It can come in many forms – cash, house, savings accounts or investments – that can be used in different ways to get you to your goals.
Focus on the strategy first. What is it you want to achieve with these tools?
Travel the world? Build a comfortable house for your family? Feel financially safe in case of an emergency? Retire early?
Then decide how you use this tool – the money – to get you where you want to be.
Behavioral Finance And Money Decisions
What is behavioral finance?
Academically speaking, behavioral finance combines research from economics, finance and psychology in order to understand the driving forces behind the financial decisions that people make.
For our purpose, we can simplify it to one of the two options: an empowering view and a disempowering view.
The empowering view of behavioral finance would be: how real people make real decisions in real life.
The disempowering view is how stupid people out there going to make very dumb decisions about their money.
When you try understanding yourself, it’s better to take away the judgmental tone, as real people aren’t perfect. I’m not perfect. You are not perfect either.
Let’s think about food for a minute. How many food decisions, do you think, everyone makes per day? Six? Fifteen? One hundred?
Usually, the estimate is around 15, but the research suggests is it’s close to 200! (Reference: Cornell study by Wansink and Dyson, 2006)
A mindless autopilot is in charge and the decisions are made without being noticed by us, blindly led by the commercialized environment that is only interested to sell more junk food to us.
As it’s impossible to fully evaluate 200 food decisions (and thousands of others), the human mind is designed to use simple rules of thumb called heuristics.
Heuristics are problem-solving methods that use shortcuts to get a good (not necessarily the best) solution with a small effort and within a short time.
For example, imagine that you need to choose between an avocado and a handful of popcorn. The popular heuristic is to think about the count of calories and consider that healthier food has fewer calories.
Sometimes, rules of thumbs led us to errors, as in this example, where avocado is actually much healthier food despite its high caloric value.
5 Beliefs That Lead To Financial Mistakes
Let’s check out five common beliefs that are actually not true and can easily lead you to wrong financial decisions or just totally hold you from taking any decision at all.
1. People Are Risk Averse
You probably think that people are risk-averse, as it’s known that losing things feels twice as bad as getting an equivalent thing feels good.
Do they always hate risk? Is a person always consistent in his or her attitude towards risk?
Let’s try this coin flipping game.
You have the choice between $20 for sure or a coin flip where “heads” is nothing and “tails” is a $100 prize.
What do you chose, the $20 bill in your wallet or flipping the coin?
About 30% will choose the promised $20 – they are really risk-averse. The remaining 70% will choose the flip. They are willing to take a risk.
In this case, the ideal rational person (who is actually risk-neutral) is supposed to prefer the flipping option, as the expected value of the outcome is higher than $20.
(If you are interested in the math, the expected value is 0*50%chance + 100*50%chance = $50)
What other factors can influence a specific person’s decision? There are many. How badly you need the $20? What impact would it have on your life? Are you hungry for food or financially safe?
Now let’s change the amounts in this game.
When flipping a coin, the prize is $20M for heads and nothing for tails. However, the risk-free choice is up to $4M as well.
What would be your choice now?
I guess, now you would prefer not to take any chances and just grab the $4M, even though it’s much less than the expected return on the coin flip which is $10M. Probably, at least 95% of people would do the same.
Why the majority of people became risk-averse in this case?
Perhaps because $4M is a huge sum that will have an enormous impact on your life and you don’t want to give it up for even for a 50% chance of getting 5 times bigger amount.
Tip: Find out what are the factors that influence your financial decisions. What are you saving for? What dollar amounts are meaningful to you? Identify them before evaluating the risk.
2. Confidence Is Good
Confidence leads to immediate actions. The lack of confidence leads to procrastination. Sounds like confidence is great, right?
But are you able to correctly access your own confidence?
Let’s take driving as an example this time. Do you feel, in general, that you are above average driver?
Majority of people do. Can it be real that the majority is above average? People want to feel like they know more than they actually do because it leads to engagement and action.
Are you confident when it comes to financial decisions?
If you are overconfident, your actions will be based on insufficient knowledge and can turn out as harmful. You might feel you know that the market has hit its lowest point and invest a big amount in stocks just before the fall continues. You might be confident that your savings account pays the best available interest, though last time you checked was five years ago.
If you are under-confident, you will be stuck with fears and inability to act at all. With so many investment options, funds and accounts, you just can’t choose the right way to invest.
By the way, research finds that there is a huge gender difference in confidence around financial decision-making. Who do you feel is more confident – Men or Women? (The answer is men).
How can you find the right level of confidence supported by real knowledge?
Overconfident people should try to diminish their confidence to a more practical level by learning more and continuously checking that their beliefs are in line with reality.
In case you feel under-confident, you can increase the level of confidence with simply asking questions and gaining more information.
Another way that benefits both sides is bringing overconfident and under-confident people together, as it leads to discussion and making better decisions.
Why don’t you have a finance-related discussion with your partner?
Share your views on budgeting, saving and investing. What are you trying to accomplish? Do you really understand the behaviors you should be engaging in, solutions and products to get you where you want to go?
To start this conversation, I recommend signing up to Personal Capital and linking all your banking, saving and investment accounts. This free software will give you a lot of valuable information about your finances and projected retirement income.
You can read my full review here.
3. Inertia – The “Hope Strategy” Works
Inertia means keeping the same cause of action or doing nothing to change it. It’s the idea that if you don’t do anything, it will be ok. Somehow. By itself. You hope.
The key idea that creates inertia is misinformation about what the result of your action might be. You don’t really know it, so you make wrong assumptions and do nothing.
Let’s say you can invest $400 a month for 40 years and the markets are really amazing making about 10% per year.
Think and write down – how much money do you think you’ll have after 40 years?
Was it a difficult or easy calculation for you? Why?
Without a spreadsheet or financial calculator, compound interest is a difficult calculation.
Many times the perceived complexity prevents people from taking an action.
Young people, like college students, think that they will have a couple of hundreds of thousand dollars at the end of 40 years. They badly underestimate the power of compound interest and use the heuristic instead.
In this instance, the heuristic uses a linear calculation, looking to add $400 for 12 months for each of 40 years. That would be only $192,000.
In reality, money grows exponentially and you’ll have well more than 2 million dollars after 40 years under these conditions!
Unfortunately, young people making saving and investment decisions underestimate the potential future amount. They disregard the cost of waiting and not starting to save early. The misinformation creates the inertia – doing nothing.
When you think about your own financial life, one of the most important factors of saving isn’t the amount saved every month.
What do you think it is?
The time when you start to save.
You need to start saving now! Stop the inertia and just do it!
The easiest way to start is with Acorns app that allows you to set up any weekly or monthly contribution or just round up the charges on your credit card and invest the change.
For example, if you buy a meal for $8.55, it will round it up to $9 and invest $0.45. This way you’ll barely feel the difference, but will be able to start investing.
Personally, I also have a $25 weekly deposit set up.
The money will be automatically invested in good quality diversified funds.
4. Having A Lot Of Choices Is Awesome.
Most human beings are attracted to a variety of choices, to making choice decisions.
I’ve told you about food decisions before. Now think about financial decisions – what to buy, when to buy, how much to pay, what card to use ….
Are your closets full of things you actually wear? Or, maybe, with things you never wear?
These closets are the cemetery for bad purchasing decisions.
When you actually are attracted to choice, the irony is, these choices end up making you NOT take action in the way you should.
One clear example is that the more investment and saving choices people have for retirement, the less they save and invest for their retirement.
Isn’t that fascinating?
People are attracted to having those choices, but can’t make a decision.
Experiment at the grocery store has found that the more options you have, especially in certain domains, the more attracted you are to it, but the less likely you are to buy it. Maybe you just get lost in comparison?
I want you to think about how you can simplify the financial choices in front of you today?
Here are some ideas:
– Have only a couple of credit cards to pay every month.
– Put money into one or two accounts
– Let a reliable automated system to decide what funds to buy with your investment money (Acorns again!)
Simplify these decisions so you are not overwhelmed and it doesn’t create inertia in your life.
5. Semantics Doesn’t Matter
Do you think the description doesn’t matter as long as it gives the correct information?
Check out the next heuristic – the framing.
Framing heuristic means making conclusions based on the framework in which the situation was presented.
How the things are framed actually transforms the way people make decisions.
Let’s use food as an example again. Do you eat ground beef?
Take a look at it next time you are in the supermarket. Ground beef is described in terms of its leanness and fat. Each label on ground beef says how lean and how fatty it is. For example, 80% lean and 20% fat.
Do you know why saying 80% lean is not enough? You would assume that everyone should be able to understand that the remaining 20% is fat.
However, there is a law that forces the manufacturer to write both values on the label.
Why do you think we need a law that ground beef must be described with both its leanness and fatness?
The reality is that if you only mention the leanness, it tends to make people buy it more and it tastes different to that human being. The information presented changes how you actually react to that food.
The idea here is that a full description is needed in order to create an objective balance in terms of the choice between leanness and fattiness that human beings should be making.
Think about framing in your financial life, how it impacts you and the choices you make?
One example of framing can be around saving and spending. When you look at your financial resources, you can think about delaying consumption, not spending money as about something negative. That’s a negative frame. The thought “I’m going to try to budget, not spend as much as I used to” – it’s depressing and not exciting at all.
Try to reframe it in the following way: “I’m actually trying to save for my future self, so my future self can spend on things. My future self is excited about it.”
You don’t believe it works?
Go and speak to another human being that you respect that is at least 30 years older than you. Maybe your parents or grandparents.
Ask them – would they have preferred to make different spending decisions when they were younger so they could have the opportunity to spend differently when they are older.
That can give you a perspective about the types of spending and saving decisions you can make now because it’s never too late.
A positive framing is a key.
Want to learn more about Behavioral Finance and Investing? Here is one great book that explains the psychological element in investment decision-making.
How To Start Making Better Financial Decisions?
In your financial life, are you budgeting or planning? Let me explain.
When I say budgeting, I mean that you are focused on making sure you consume less than you bring in. If that’s your focus, ask yourself 3 questions from a behavioral standpoint
♦ What are you spending on? Don’t go through the bills or credit card reports, just think about it.
♦ Are the things you are spending on aligned with your values? Yes or no? Make it simple.
♦ How you could start eliminating things that are not aligned with your values? Not all at once, maybe just one or two every month.
If you have the benefit of being past budgeting, meaning you are actually consuming less than you earn, then perhaps you are planning for the future – saving or even investing. That’s the whole different idea.
Think about 3 concepts for financial planning:
♦ How much cash do you have available to meet rainy day expenses or, in other words, as an emergency fund? The amount required can be different, based on your spending habits, values. Does that amount make you feel confident, comfortable, with peace of mind in your financial life? Remember, about 40% of people say they couldn’t manage a surprise $400 expense, without borrowing money.
♦ Your current lifestyle. How much are you spending every month? Do you really know this information? Many human beings don’t, no matter who they are. It’s going to be hard to save or use money as a tool if you don’t know how you are using it currently.
♦ Is that spending rate sustainable? Can you spend that same amount of money for the rest of your life?
With these answers in mind, use the following steps to make better decisions for a brighter financial future.
1. Define the situation with a positive attitude
2. Decide how much risk are you willing to take and why
3. Get enough information to make a confident decision
4. Eliminate excess information. Decide on a small set of options
5. Take the action!
For example, start saving NOW – open Acorns account.
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What mistakes did you make?
Share your tips for better financial decisions in the comments.