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The Psychology of Money

February 13, 2019  |  #Finance #Money Management

We all make silly decisions with our own money. Think you are an exception?

Everyone is dumb with their own money. Trust me, it’s true. Each of us is. No matter how smart. No matter how financially adept. No matter the experience. We all make silly decisions with our own money. Think you are an exception?

  • Have you ever been excited by an opportunity and jumped in before you even realised what you were committing to?
  • Have you ever made a financial decision because you were scared of what might happen if you didn’t?
  • Have you ever been confused by the choices available?
  • Have you ever been rushed into making a quick decision?

If you think the answer to all of those is ‘no’, it’s likely you are in denial.

We say this with a bit of tongue in cheek – but the reality is that as humans, we are not built for making consistent rational well-researched decisions about money. There is far too much of ‘life’ living in between our values and aspirations, and our actions. Too much emotion. Too much instinct. Too much history. Too little time.

Even our experts here, who live and breathe financial advice for a living, work with another adviser when it comes to managing their own money.

When you dig into the Psychology of money – what drives our behaviour, there are few key reasons why we are not built to manage our own money.

 

Understand how your decisions and actions today may affect your financial security tomorrow. Get in touch.

 

Rational Decision Making

When we take on our own affairs, we do so with the presumption that we are going to be able to do the research and make rational decisions about what to do. Unfortunately, that is not how our brain works. 95%i of the decisions we make are made using mental shortcuts or rules of thumb. That means we are heavily filtered by our existing knowledge and experiences. Even if the research is pointing in one direction, if it is contradictory to our past it will be a difficult decision to execute.

Prospect Theory

We are geared to dislike loss far more than we are to appreciate gain. Take the following example:

Which of the following would you prefer?

  1.  A) A certain win of $250, versus
    B) A 25% chance to win $1000 and a 75% chance to win nothing?
  2.  How about:
    C) A certain loss of $750, versus
    D) A 75% chance to lose $1000 and a 25% chance to lose nothing?

Tversky and Kahneman’s work shows that responses are different if choices are framed as a gain (1) or a loss (2). When faced with the first type of decision, a greater proportion of people will opt for the riskless alternative A), while for the second problem people are more likely to choose the riskier D). This happens because we dislike losses more than we like an equivalent gain: Giving something up is more painful than the pleasure we derive from receiving it.

The way this plays out for us with our own money is a skewing of health risk-taking behaviour. By avoiding ‘loss’ we end up acting in a riskier manner.

Mental Accounting

We humans think of value in relative terms rather than absolute. We also have a very hard time factoring in opportunity costs (the cost we don’t necessarily experience but are in fact real given the potential benefit of an alternative solution). We are also susceptible to the ‘sunk cost’ fallacy – we over-value something based on the cost incurred to acquire it, not factoring in the ongoing benefits or costs. Because of this, we tend to treat money differently based on how we have come upon it and what it is intended for.

Limited Information and Feedback

When we don’t see an immediate outcome, we tend to skew our decision making. For example, we all know smoking is bad, but smoking one cigarette doesn’t show us immediate harm, therefore it can be hard to make a rational decision about whether to light up. The same can be said out investment and savings. WE all know that if we save a bit regularly and do that over a long period of time, we will be in a far better financial position than if we try to save a lot later on. But small amounts don’t show big results at the time. Therefore, it is easy to delay action. Without regular feedback about our actions, we tend to overestimate the wants and needs of our current self to the detriment of our future selves.

Status Quo Bias and Inertia

We tend to prefer things to remain the same and are only willing to make a change when we feel like the status quo is lost. Generally speaking, we dislike change and will only undertake the effort to live through it if we feel like we have no other choice. The status quo has to become too uncomfortable for us to stay.

Time discounting and present bias

We tend to prefer our present self and are motivated to cater for today’s needs because we are bad at predicting future experiences, values and behaviour. We tend to be too optimistic about the future.

Social Dimensions

We are influenced by the social norms of our peers and community which can lead to making financial decisions out of ‘compliance’ rather than from a place of individual prioritisation. If everyone around you is renovating, you may go down that path, even if there are other things more important to you to spend your money on.

 

These are just a few of the reasons why we are bad at making decisions about our money. So, what can we do about it?

If we shouldn’t do all our own money management, who should we trust to help us?

How do we ensure we make smart decisions as we move through life?

Stay tuned… soon we will discuss some strategies to help us, from ourselves! If you would like to learn more about our trusted advisers at Invest Blue, please get in touch. According to the theory of Heuristics.

What you need to know

This information is provided by Invest Blue Pty Ltd (ABN 91 100 874 744). The information contained in this article is of general nature only and does not take into account the objectives, financial situation or needs of any particular person. Therefore, before making any decision, you should consider the appropriateness of the advice with regards to those matters and seek personal financial, tax and/or legal advice prior to acting on this information. Read our Financial Services Guide for information about our services, including the fees and other benefits that AMP companies and their representatives may receive in relations to products and services provided to you.  https://www.apa.org/pubs/highlights/peeps/issue-105.aspx  https://www.behavioraleconomics.com/resources/introduction-behavioral-economics/


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