And newsflash no matter what our internal voice is telling us we are all smart. It’s just as factual that we all make bad money choices at one time or another.
This is not because we are bad with numbers or stupid, it is simply our prehistoric protective brain running its “keep me safe” programs. This takes us down the path of behavioural finance concepts and why we do things with our money that seem irrational.
Researchers point to 5 distinct behavioural finance concepts that drive our money decision making:
- Mental Accounting
- Herd Behaviour
- Over Optimism
- Present Value
This is one of the strongest drivers of bad financial decisions and rests on how we treat money differently depending on the use we have earmarked it for and the source it comes from.
An example given by Richard Thaler, a Professor of Economics at the University of Chicago who introduced the Mental Accounting concept, is where an individual receives a windfall or unexpected cashflow. This is treated as “easy money” and often goes straight into discretionary fun spending and is less likely to be directed to supportive money actions such as paying off debt or additional payments to a mortgage, pension, savings and investments.
Another common example mentioned by Thaler is where we have created a special savings account for vacations or a house deposit into which we regularly deposit money while also carrying substantial interest bearing credit card debt. Not connecting the fact that the interest being paid on the credit card debt far outweighs any interest we may be receiving on our savings and that this action is eroding our money balance.
Why do we implement these seemingly irrational steps? We place differing values on things we want and those we theoretically need based on our biases. Many people consider saving for a house or their children’s college fund their most important goals and struggle to relinquish this belief even if it isn’t beneficial and supportive of growing wealth.
We make the same flawed mental accounting in our investment decisions. Consider we have two assets, one is profitable and the other loss making. We need to sell one to release some cash. Which do you think we should sell?
It seems obvious to me to sell the profitable one. This is not a rational decision though and likely stems from my aversion to losing money. I would rather keep an unprofitable asset than accept the loss a sale would incur. Not such an obvious choice when put like that!
This is another of our Mental Accounting biases, we have an ingrained bias to loss aversion and will act irrationally to ensure we don’t feel the pain of loss even if the potential to gain is larger.
A key human driver is to want to stay in the protective familiarity of the herd. The fear of being excluded, missing out or making a contrary choice that turns out wrong drives our deep desire to rely on the choice of the masses as opposed to our own rational analysis. This behaviour is notorious for creating wild swings in the stock market without any changes in the fundamentals to support them.
This is our tendency to lock onto one information source with resonates with us to the exclusion of any contradictory or contrary views. In the context of money we often fall for clever marketing tactics where the advertiser quotes an initial high price for the item, which we then fix as our measuring point, and then “surprises” us with a limited time, lower price. We base this new offer off the original price rather than validating whether it is in fact a bargain through external comparison.
More dangerously though, this can impact on our big purchasing decisions such as buying a house or car. We tend to lock onto the current monthly repayments and use this as our benchmark for affordability. We don’t consider a change in interest rates on our ability to repay or in the case of the car, how much more we may end up paying by going the financing route.
Anchoring leads smoothly into the next behavioural finance concept, Over Optimism. Yes, there are those who will always be “glass half full” pessimists but the general population is naturally optimistic, especially when it comes to the future and our tendency to put the rose tinted glasses on when looking towards it. This makes us less likely to buy into the need for insurance and once again undermines our ability to save for our future selves as we believe, from our optimistic state, that everything will work out at some point!
We overweight the present and find it easier to place a value on it. This reinforces our tendency to want immediate gratification.
We find it difficult to step into the future as it is a far less tangible and meaningful to us now. This further undermines our ability to take actions which detract from our present situation to provide for our future one. This is why it is so difficult to voluntarily put money aside for when we retire, especially when we are younger and retirement seems such a distant possibility. Ironically is when it makes the most sense to do so at this stage.
Why is it so difficult to change our money behaviour?
Our brains simplistically operate on two levels. The unconscious, automatic level where most of what we do happens and the conscious reasoning level, which for the most part is totally unconscious of what is happening on the first level.
The first level is very good at simplifying our responses by creating habits and once part of our mental operating system, these are extremely difficult to identify (being unconscious and all) and as a result extremely difficult to challenge.
What can we do to change these old money habits?
An article by Carolyn O’Hara in Forbes Magazine compared our brains to software created by Microsoft. The Microsoft Engineers were all about efficiency and didn’t start rebuilding our brains from scratch to adapt to the new environment we live in. As a result they left the old prehistoric “fight, flight and scarcity” operating system and simply added new software on top of this. As a result we are to some extent stuck with our old reactions and responses.
She goes on further to relate the two levels of our brain to an elephant and its rider. The elephant is the old prehistoric part of the brain and the rider the rational thinking part. The thing is the rider will go nowhere unless he gets the elephant to move in the direction he wants it to go. The rider basically has to motivate the elephant to want to take action and he can do this by starting to talk to the elephants reward centre.
Incentives have to be created to get the elephant on board so to speak and this is where the rational part of our brain can really come into its own with the creative elements of visualisation, and imagination. Our elephant brain cannot distinguish between emotions based on fact and those created by visioning. To the elephant if it feels so, it is so.
Creating a rich, vivid image of what we want to achieve in the future excites and inspires our elephant and starts the shift in habits through our ability to start recognising those that aren’t supportive of us achieving our vision.
The elephant though is easily bored and distracted and it’s important to keep the vision a living breathing reality. This means setting challenging short term goals that work towards our larger vision. Set monthly, quarterly, half yearly and annual goals to pay down debt, build pensions, savings and investments and keep the elephant engaged and the rational mind active. Make it a measurable money game, because ultimately that is what it is. Money is merely the tool that helps us hit our game milestones and lead to us winning the game we are playing.