The financial decisions you make today have a lasting impact on your economic well-being in the future. While you might believe that your financial choices and decisions are deliberate, some decisions you make are sometimes rooted in unconscious behaviour patterns and biases that go unnoticed. In this blog, we delve into behaviour patterns that can often obstruct your financial decision-making process, potentially hindering your ability to make informed choices that can pave the way to achieving greater, long-term financial success.
You’ve probably heard of the term herd mentality. Herding behaviour is the natural tendency to follow the crowd. As humans, we naturally look for ways to shortcut decisions. Herding is one way we use how others behave to make our own decisions more quickly.
Fear of missing out (FOMO) is an example of herding behaviour. Black Friday sales that trigger a lot of spending create a herding mentality. There is no evidence that deals on Black Friday are better than other sales throughout the year. We can also resort to herding behaviour when we feel financially overwhelmed and need to make a quick decision without exploring all our options.
Herding can be a double-edged sword. On the one hand, it can make sense because it provides a quick decision-making shortcut, but in other ways, herding can cost you a lot of money.
Therefore, herding behaviour may lead to financial choices that are not always in your best interest. Herding can have detrimental consequences, especially when making investment and financial decisions such as buying a new home. It’s always important to ask yourself if you are making decision-making shortcuts beneficial to your long-term plan.
The Endowment Effect
The endowment effect is a principle of behavioural psychology that describes the tendency of people to place a higher perceived value on an object they already own than they would if they didn’t own it. The mere act of ownership increases the perceived value placed on an object, especially when you have a built-in emotional attachment to that object.
The cause of the endowment effect is often related to what is known as loss-aversion psychology or loss aversion bias: a phenomenon where a tangible or potential loss is perceived to be psychologically or emotionally more severe than an equivalent gain.
For example, the joy of losing $100 is often far greater than the joy gained by finding the same amount. People tend to feel the loss is greater than the equivalent gain. It can make managing financial expectations more difficult.
When you overvalue things like your home, you can inflate the sale of your home at a higher perceived value than its market value, which can have consequences on your long-term financial plan, especially if you are counting on the equity built up in your home as part of your retirement nest egg.
Present bias is when we value something we can have right now over waiting for it; the natural inclination to favour immediate rewards over future benefits. For example, ask most people if they would rather have $100 today than wait a year from now for $120.
Present bias can conflict with long-term goals like retirement planning and result in impulsive decisions that may not align with your long-term financial goals. As a society, present bias is the most prolific and influential behaviour we resort to that undermines our financial goals and success as we have programmed and hardwired for “instant gratification.
Confirmation bias is the tendency to seek out information or interpret information that confirms pre-existing beliefs at the expense of ignoring conflicting information you are presented with.
A confirmation bias approach to decision-making is largely unintentional but results in ignoring information inconsistent with your beliefs, thereby hindering objective decision-making. You unconsciously seek and search for information that confirms what you believe rather than remaining open and considering different viewpoints or other information when making financial decisions. In doing so, you risk eliminating financial advice and opportunities you may benefit from because you remain mentally closed off to them.
When experiencing high levels of financial stress, we tend to avoid looking at or dealing with our finances. For example, if you are stressed paying down a high credit card balance, you may be more likely to miss making a payment on time because you’ve “mentally” checked out by not paying attention.
It’s common to seek useless information as a distraction (such as scrolling on social media) to deflect or avoid useful information (looking at your credit card statements) because it makes us feel bad to look at. However, focused attention, the opposite of selective attention, is the behaviour you should practice when your finances are stressing you. One of the best ways to manage your finances is to be accountable and choose not to look away. Selective attention only creates stress and won’t make your financial challenges or your credit card balance disappear.
The licensing effect, also known as self-licensing or moral licensing, is when we allow ourselves to engage in destructive behaviour after doing something good. To put it bluntly, productive, or good behaviour can lead to poor behaviour. For example, say you save $500 in an emergency fund but then reward yourself with a shopping spree for your accomplishment. The shopping spree defeats the goal of saving $500 to begin with. Such behaviour is counterproductive to setting and reaching your short-term and long-term goals.
Windfalls can also lead to free falls. When you come into an unexpected or significant amount of money, it can lead to overindulgence and spending. In this way, licensing can also undermine your financial goals.
Choice overload bias is when presented with too many options or choices, and the mind becomes overwhelmed. Too many choices can lead to decision fatigue, sticking with a default option that might not be your best option or decision paralysis.
Choice overload is dominant in the insurance and investment industries, given the plethora of products on the market. Working with a financial advisor or life insurance broker can help you narrow down the choices and the number of decisions you must make when looking into a financial product, strategy, or concept.
In conclusion, your financial future is profoundly influenced by your behaviours and biases, often shaping the financial path you tread without ever realizing it. Herding, the instinct to follow the crowd, can expedite decision-making by taking shortcuts that might lead to costly choices and consequences.
The endowment effect attaches emotional perceived value to what you already possess, which can distort financial planning and lead to financial decisions and planning that might not always be in your best interest and impact your long-term financial goals.
Present bias, the preference for immediate rewards over future benefits, can also sabotage retirement plans and financial goals due to an innate desire for instant gratification.
Confirmation bias can prevent you from considering alternative viewpoints or thinking outside the box of your beliefs, potentially missing out on beneficial financial opportunities. Selective attention, especially during financial stress, can lead to avoidance of dealing with our money and finances. In contrast, focused attention is essential for effective financial management.
The licensing effects tempt us to indulge or overindulge after a financial win, potentially undermining our financial goals. Lastly, choice overload bias can overwhelm us with options, leading to decision fatigue, default choices, or avoidance. Sometimes, less is more.
Recognizing and understanding these behaviours and biases is the first step to making more informed and responsible financial decisions. By doing so, you can gain greater financial control for your future, making choices that align with your long-term goals and helping to secure your financial future.
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