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Understanding the psychology of money
Unconscious bias and learnt behaviours affect your approach to money and investment.
For many of us, the process of saving, investing and looking after our money is an ongoing struggle. If we live from paycheque to paycheque, we often struggle to find ways to get ahead of our expenses and the cost of living.
This is usually the result of our habits and how we behave with money, rather than conscious knowledge and analysis. We might believe that we manage our investments and personal finances using data and statistics to ensure good decisions, but most of us make financial decisions according to unconscious emotional attitudes about money. Our financial choices are often based on anecdote, personal experience or everyday advice and conversations.
Cognitive biases and financial behaviour
Behavioural economics is a relatively new field of study that looks at the difference between reality and our beliefs about saving and investing. It investigates why we make the financial decisions that we do, and how to change these decisions for the better.
Traditional economic thinking assumed that most people make rational decisions based on the information they have to maximise their personal benefit. But often the buying decisions we make are not completely rational and are influenced by behaviours like heuristics and emotional biases. Heuristics are the models or mental shortcuts we use to solve problems and make judgments quickly. They can give rise to wasteful behaviour, like buying an additional item at the supermarket because of a ‘buy one get one free’ offer, even if you won’t be able to use all the contents before the use-by date. Biased thinking is an inclination to believe something without rational proof, because the belief makes you more comfortable.
Increasingly, behavioural economics is being applied to the choices we make about personal finances – for example, whether you pay the minimum or more on your credit card, whether you save instead of spending, or what car you buy. The so-called ‘pain of paying’ may cause you to prefer using credit cards instead of cash, so that you don’t see the money you’re spending. In an increasingly cashless society, this is becoming a bigger behavioural challenge.
A financial adviser can give you an expert, rational, external perspective
Other choices are driven by what behavioural economists call the ‘empathy gap’. This refers to how our inability to assess our own mental state can affect our buying behaviour. The consequences can range from something as simple as underestimating your appetite when you go out for dinner, to predicting accurately how you will afford big-ticket purchases in the future.
The psychology of investment decisions
Whether you’re making your own investments or using a broker, be aware that investment professionals share a similar set of biases and behavioural quirks with the average person in the street. They include the following:
1. The market paradox
This is common in investment markets. For the markets to be efficient, investors must believe that they are inefficient. In other words, investors must behave as if markets won’t react predictably to new information.
2. Herding
This refers to investors buying or selling shares in a particular company or sector simply because others have already done so. Individual investors are prone to this behaviour when they see institutions buying and selling like this. Herd behaviour can cause mass buying in a market sector, leading to the notorious stock market ‘bubbles’ that have bedevilled the global economy repeatedly.
3. Loss aversion
This describes the behaviour of investors who avoid investments that risk losses over the short or medium term.
Understanding our cognitive biases about money
Here are some of the most common cognitive biases that affect our money and investment decisions:
1. Self-attribution bias
The belief that good investment results are due to your own skills or knowledge, but that bad investments are due to poor luck.
2. Confirmation bias
Concentrating only on data that confirms your investment beliefs, while ignoring any that doesn’t.
3. Anchoring bias
Being influenced by the first number or price you encounter can distort your perception of market trends.
The financial impact of emotional decisions
To combat the negative impact that emotional behaviours can have on your buying and investment decisions, learn to make decisions on a more rational, considered basis. One way of achieving this is to manage your stress, because stress shuts off your ability to think logically and coherently.
When you’re cognitively impaired in this way, the following happens:
- You don’t listen as well.
- You have a shorter fuse and often feel impatient.
- You tend to obsess about the past and worry about the future.
Clearly, making financial decisions under these conditions is unwise. It’s important to be in a place where stress is not a decisive factor when you make major investment or financial decisions. Take a step back from important issues while you consider which biases or behaviours might be impacting your decision-making process.
A financial adviser can give you an expert, rational, external perspective, which often helps you see past subconscious biases and behaviours. They can help make the potential risks and rewards of investments or financial choices clearer, from an analytical rather than emotional perspective.
When you invest or make important financial decisions, you need informed, expert advice. Join the bank that’s best for your money, and you’ll get access to everything from general business banking advice to the stock trading and investment expertise of Nedbank Private Wealth.
