By Timothy Ulbrich, PharmD
We’ve all made financial decisions that probably weren’t the smartest. We may have thought the decision was rational and logical when in reality it wasn’t. Maybe you didn’t take advantage of matching retirement funds from an employer or bought an expensive item and thought you would easily be able to make the monthly payment. These financial choices all trace back to behavior.
Behavioral economics, or behavioral finance, blends both economics and psychology and shows why and how people make irrational and illogical decisions with their money. Unfortunately, our financial behavior can lead us to be broke, even with a high income. To be financially successful, it is imperative to look at your behavior with a critical eye. By doing so, you may be able to break bad habits or improve how you make decisions that move you closer to your financial goals.
While there are many behavioral biases that affect everyone, I will review five common biases.
Overconfidence
Failing to look at potential risks or thinking that every aspect of your life will remain the same can be dangerous to your financial health. Overconfidence can lead you to purchase a house without a down payment or live without disability insurance, or try to time the market and pick individual stocks. Although some of these may seem harmless, the danger comes in to play when something about your life changes. What if your house doesn’t increase in property value or you get in an accident and can’t work?
To overcome this overconfidence bias, you have to think about the negative potential outcomes that could occur and adjust your decisions
accordingly. Strategies to overcome this bias include having an emergency fund, ensuring proper insurance coverage is in place, and resisting the urge to time the market and pick your own stocks in an attempt to be the next Warren Buffett.
Hyperbolic discounting
Have you ever wanted something so badly that you impulsively purchased it and weren’t able to wait for something better in the future? This desire for instant gratification pushes us to be more impetuous with our money and is the biggest reason why people are broke.
Hyperbolic discounting can be seen in many areas of our financial behavior. When we don’t think about our long-term financial goals, like having a fully funded retirement account and the joy that will bring, we might instead use our money to buy clothes, cars, or other items of depreciating value. Although we may be happy in the moment with these purchases, we might not be come retirement.
To counter this, set future goals and break them down to see exactly what you need to be doing in the present moment. Remind yourself of these goals daily so that you can move past the desires and develop better habits.
Loss aversion
No one wants to lose something that they have worked hard for. This fear of losing money may push us to make decisions that avoid risks, potentially making us miss out on increasing our wealth.
Loss aversion is seen in avoiding the stock market and instead saving in forms of cash, savings accounts, CDs, or treasury bills. Although your money is “safe” in these investment vehicles, you are probably losing money over time due to inflation. This bias can also make you pull investments out of the market too soon.
Status quo
Not doing anything with your money can have as much of a negative impact as making poor decisions with it. Like loss aversion, people feel like they are losing money if they change the way they are spending or investing it.
Instead of holding on to fear of what could happen to your money, think about how you would feel if everything actually worked out and you gained money. If you are overwhelmed by too many choices or options for investments and stuck in the status quo, consider hiring a professional to help limit choices and join you in making the decisions.
Herd mentality
Making financial decisions based on how others are behaving is known as herd mentality. It is easy to follow what other people have done, but this can easily lead you to being broke.
Avoid anything that will make you act impulsively, don’t invest in something that is trending just because others are doing it, and stop listening to people that are losing money instead of gaining it.