Over my life, there have been a lot of things I intellectually understood, but didn’t do.
When I was younger,I knew staying out late and drinking too much was bad for me. But I did it.
During that time, I also knew that I should have a budget, keep a close eye on my cashflow and be a good steward of my money. But I didn’t do those things.
To this day, I intellectually know I should learn from the mistakes of others instead of making them myself. But I still insist on personal experience.
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 becoming aware of 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 make decisions based on personal biases instead of facts.”
Our brains are awesome tools and, for the most part, they benefit us greatly. But, they’re not necessarily serving us when it comes to our finances.
Having a better understanding of behavioral finance and how it applies in your life will help you get better at money, which will result in a better and richer life.
Here’s what we’ll talk about:
- Ideal versus real
- Our brains and money
- Common biases
- The simple path to wealth
- A sacrifice is required
Transition – Let’s get into it H2
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 are never going to 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 possibly can, and not try and 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 awesome 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?
I was taken aback 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 start to 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 start making 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!”
In terms of escaping a burning building, the response is extremely helpful. But when it comes to our investments, not so much.
You see, 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. Becoming aware of, 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 tend to believe ourselves to be more competent than we actually are.
- Confirmation bias: We do this all the time. In the context of 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 to be 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 onto bad investments for far too long.
The simple path to wealth
Financial success is available to everyone, but found by few.
I believe there’s a three-step process that needs to be followed.
- Define success. If you don’t know what success looks like, how will you know if you have it? To figure this out, it’s imperative to get clear on your values and goals. (You can access our Values and Goals courses at no cost).
- Put a plan together. You know where you want to go, now it’s time to create a plan for getting there. (Our DIY Financial Plan course can help you with this).
- Execute your plan. Complete the required steps in your plan.
This is an example of “Sounds easy, does hard.”
There are a lot of things standing in our way. We talked about the challenges presented by our brains. And then there’s our egos and our appetites. We need to address those as well if we hope to execute our plans.
A sacrifice is required
The Stanford marshmallow experiment in 1972 documented the challenges of delaying gratification. In the experiment, researchers presented kids with a marshmallow which they could immediately eat, and the option of waiting to eat and getting more.
The kids who were able to delay gratification ended up being more successful in life.
And so it goes for you and I.
To create a better future for ourselves, sacrifices must be made today. We must choose to delay some pleasure and gratification to a later date. This is true for every aspect of our lives from eating, to exercise, to money.
Are you willing to control or deny some of your appetites and impulses?
Or will you be the kid who eats the marshmallow?
Financial stability and success have requirements.
They require not only knowing what to do and how to do something, they also require making tough decisions on a daily basis.
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.
Let us know how we can better support you on your path to wealth!
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