We all want to know how to be good at financial decision making. And it’s easy, but it’s not simple.
It’s impossible for anyone to eliminate all bad decisions. What we want to do is minimize how many we make. The wrong financial decision can delay our most important financial goals.
Being human is to be both logical and emotional. We can understand something intellectually, but still act emotionally.
Over my life, there have been a lot of things I intellectually understood, but didn’t do.
While I’m getting better, I still have to learn certain things for myself instead of relying on the wisdom and experiences of others.
The gap between knowing and doing has been consistently closing for me as I’ve gotten older, but I have a feeling it’s always going to be there in some form. And that’s ok, because I’m aware of it.
For me, behavioral finance is all about realizing that gap as it relates to our money. Awareness is the first step in closing it.
A technical definition of behavioral finance is this from Kaplan:
“Behavioral finance is the study of the effects of psychology on investors and financial markets. It focuses on explaining why investors often appear to lack self-control, act against their own best interest, and decide based on personal biases instead of facts.”
Our brains are outstanding tools, and mostly, they benefit us greatly. But they’re not necessarily serving us with our finances.
Having a better understanding of behavioral finance and how it applies in your life will help you get better at money, which lead to a better and richer life.
As a financial advisor, I’ve been helping people learn to make better decisions for 20+ years. I’m honored to be named to Investopedia’s list of the top 100 financial advisors many years running.
Here’s what we’ll talk about:
- Ideal versus real
- Our brains and money
- Common biases
- Overcoming our biases
Let’s get into it.
Ideal versus real
If we lived in an ideal world, there’d be ideal scenarios.
But we don’t, so there’s not.
The same is true for our finances. We don’t live inside a spreadsheet, so our finances will never play out perfectly. And that’s OK.
We need to know ourselves and our brains, so we can do a better job of getting to where we want to go. We need to be as real with ourselves as we can, and not try to sugarcoat things.
We’ve all made mistakes, and we’ll make more in the future. As we become more aware of them, and our motivations behind them, we become more likely to avoid them.
To do this, we need to understand how our brains operate.
Our brains and money
“This is your brain. This is drugs. This is your brain on drugs. Any questions?”
Do you remember that 1987 anti-drug TV commercial? If you don’t, do yourself a favor and check it out on YouTube.
Our brains are amazing. They’ve kept humanity going for six million years. But, they’re not exceptional at money.
What percentage of your financial decisions do you make emotionally?
Nobel Prize-winning Economist and Psychologist Daniel Kahneman figured out it’s around 90%.
What do you think about that?
It took aback me the first time I heard it. I thought, “No way. There’s no way I make 90% of my financial decisions emotionally.”
But then I thought about it.
And the more I thought about it, the more I started believing it. Once you pay attention to how you think about and make financial decisions, you’ll be able to bring that percentage down. You’ll be able to make more of your financial decisions based on logic and reason. And that’s what we want.
Here’s another interesting fact; the part of our brain that handles our finances is the same part that handles mortal danger. So the feelings and responses we get when we smell smoke are the same as when we check our 401(k) balance and see it’s declined 20%. Our brains tell us to “Run!”
To escape a burning building, the response is extremely helpful. But for our investments, not so much.
I intellectually understand I’m supposed to buy low and sell high. But my brain wants me to do the opposite.
When it sees my investments have gone down, it tells me to sell.
Conversely, when it sees an investment at an all-time high, it tells us to buy. Our brains want us to avoid pain and to seek pleasure. This is often the opposite of successful financial behavior.
We’ve all got biases and blindspots. Realizing and spotting them when they’re happening is how we overcome them.
Here are the most common and how they show up:
- Self-attribution bias: Our egos love taking credit when things go right, and redirecting blame when things go wrong. We also believe ourselves to be more competent than we actually are.
- Confirmation bias: We do this all the time. In finance, we seek information to confirm our existing beliefs or hypothesis.
- Representative bias: We make this mistake by comparing one investment to another we consider being similar, but may have a completely different set of facts.
- Framing bias: This happens when we make poor decisions based on how something is presented, instead of judging on merits alone.
- Anchoring bias: We put too much faith on the first piece of information we receive. Instead of looking at new information objectively, we allow it to be influenced by the initial info.
- Loss aversion: The pain of loss is said to be twice as powerful as the desire for gain. This fear often causes investors to hold on to poor investments for far too long.
Overcoming our biases
Success with behavioral finance means knowing there’s a gap between what we know and what we do. Awareness is the first step in closing it.
Learning about the various biases that exist is the starting point. Next, we need to become more mindful and recognize when we’re experiencing them. From there, it’s having the discipline to make the logical decision instead of the emotional one.
It’s also wise to have someone you can bounce thoughts and ideas off of. When we’re facing an important financial decision, being able to talk through it with someone else can be valuable. If you have a partner, it can be this person. If that’s not available, find a trusted friend you can have this serious conversation with. Working with a financial professional could also solve this problem.
Embracing the logical and emotional parts of ourselves is essential. We’re never going to get rid of emotion in our decision-making process. Therefore, we need to become adept and managing it.
Financial success requires paying attention to your thinking and behavior around money. It requires being aware of things like behavioral finance.
It’s hard to develop new habits, but easier to keep them going. Like all muscles, as you use and exercise it, it gets stronger.
Having a better understanding of behavioral finance and how it applies in your life will help you get better at money, which will lead to a better and richer life.
If you’re ready to take control of your financial life, check out our DIY Financial Plan course.
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