Traditional economic theory assumes people act rationally with self-interest at heart. But when it comes to money matters, theory and reality often collide.
Our emotions and instincts can have a powerful impact on our decisions. Weight loss for instance is often dictated by the straightforward concept of consuming fewer calories than we expend. Yet we often give in to a naughty slice of mud cake even though we’re not hungry.
Similar emotions can shape the way we manage our money. Let’s take a look at how behavioural science explains the hurdles can that hold us back.
Let’s face it, doing nothing is often easier than doing something.
We all know for instance, that we need to save for retirement. The trouble is, getting started can seem like a lot of hard work (even though it isn’t).
TIP: Don’t let inertia stand between you and your financial goals. The first step is often the hardest, after that, everything gets easier.
2. Recency Bias
This describes the tendency we have to place undue emphasis on recent events.
A particular share for instance may have served you well for years. But a sudden dip in the stock’s market value can colour your view, and now you’re not so fond of it.
This bias can explain why investors tend to buy when share prices are high and sell them at a low point, which is of course, exactly the opposite of successful investing.
TIP: Always have your sights set on long term financial goals to avoid making knee jerk decisions.
This is our tendency to rely heavily on the first piece of data we’re given. For instance, an investment property may be listed for sale at $500,000 – this sets the anchor. When we negotiate on price, we’re likely to base these negotiations around $500,000 even if we are presented with data showing the place is only worth $400,000.
TIP: Don’t place too much value on a single piece of information. Research widely and tap into independent advice to overcome the impact of anchoring.
4. Loss Aversion
This one’s an oldie but a goodie. It explains how the pain of losses tends to outweigh the pleasure of gains. In other words, if you’ve owned shares that have fallen in value, you may be unwilling to invest in those shares again, even though their value is set to soar.
TIP: Having an adviser by your side can be like having a money mentor, who can help you recognise and push past loss aversion.
5. Status Quo Bias
As humans we have a tendency to like things just the way they are. Put simply, we can be change resistant. For example, if you’ve invested only in rental properties you may be anxious about investing in shares because they are unfamiliar, even though they may be more suitable for your investment goals.
TIP: Growing wealth relies on multiple strategies. Be prepared to try something different, with expert advice – it can mean accessing new ways to save or make money.
Our natural human biases can be hard to overcome. But it’s not impossible. Simply being aware of these irrational behaviours is the starting point to moving beyond them. And that could be exactly the step you need to take to achieve your full wealth potential.
At Mortgage Choice, our financial advisers can give you the benefit of advice tailored to your circumstances. It can be your best tool for navigating those irrational decisions.