Understanding psychology can help you make better financial decisions
Do One Thing: You can know the lessons of good personal finance (save more, spend less) through and through — and yet, not be able to cement solid sustainable habits. The reason may be simply how you’re wired. Pick something to automate (a per-paycheck contribution to emergency savings or a target date fund for your retirement account) that can get you out of your way and stop you from sabotaging yourself.
Have you ever impulsively bought something — maybe a pair of pants, maybe the latest generation headphones — and then wondered: “Why did I spend so much?” Or maybe you skipped putting money in your savings and regretted it when your car broke down? It might feel like it’s impossible to make better money choices (particularly in the moment) but that’s probably because you’re working against your instincts instead of with them.
What is Behavioral Finance?
An entire academic discipline, the field of behavioral finance has developed over the past couple of decades to help us account for our irrationality when it comes to money. Investopedia defines behavioral finance as: “the study of psychology as it relates to the economic decision-making processes of individuals and institutions.”
I prefer to think of it as the study of why smart people do stupid things with money.
And the great thing about behavioral finance is that it doesn’t just tell us what we do wrong, it flips it on its head and helps us reverse course. Dan Ariely, author of the new book Misbelief: What Makes Rational People Believe Irrational Things, is the James B. Duke Professor of Psychology and Behavioral Economics at Duke University. He breaks down 3 common money mistakes — and how you can use behavioral finance principles to stop making them.
1) You let your emotions get the best of you…
Biologically, emotions serve an important purpose — they spur immediate action to satiate hunger or avoid danger, and they help us form relationships that make our lives better. But when it comes to money management and investing, emotions can make you act in ways that hurt your financial well-being.
For example, you might be overly afraid of losing money — that’s a behavioral finance phenomenon known as “loss aversion”. That might lead you to hold onto a stock that plummets in the hopes of recouping your money, even when selling it would minimize your total losses. Or, your neighbor’s new convertible might lead to intense FOMO that makes you start looking at new cars, even when yours is only a few years old.
… but strict rules for yourself can help.
You can’t eliminate emotions. But you can set up rules for yourself to limit their effect, like a waiting period on discretionary purchases or a separate card for frivolous spending. “Let’s say I’m going to put $100 a month into a prepaid debit account,” Ariely says. “And at the end of the year, then I’ll decide — what’s the thing I most want to do with this frivolous spending account?”
And, when it comes to those investment losses? Think about turning off the TV so financial news doesn’t stress you out and cloud your judgment, or consider putting your money into a target date fund so that your asset allocation isn’t subject to the whims of the market.
2) You don’t think about opportunity costs…
One of the first lessons you learned about money was probably that buying one thing usually means not buying something else. The problem is that making smart purchases can be hard because figuring out the opportunity cost of your decision is hard, too.
What’s unfortunately way too easy? Getting tunnel vision. You’re probably not thinking about the cost of a nice dinner with your partner or the money you need for vacation when you’re grabbing takeout at lunch. Plus, thinking about everything you could do with that $6 is impossible. There’s just too many choices.
… but you can make it easier to consider the alternative.
Ariely says the trick is to think about just one other way you could use the money, which helps you personalize your spending decisions to your needs and wants. “When I think about purchases, it makes sense to think in terms of trade-offs,” he explains. “Do I prefer this shirt, or do I prefer to go three times to the movies?” A film buff should leave the shirt on the rack, but someone more fashion-conscious might want to take it home.
3) You let your money be ‘out of sight, out of mind’…
Many of the best things you can do for your financial health are invisible. When you buy a sweater, you get something in return — but saving for retirement doesn’t give you anything tangible. Payment method matters too, because it’s harder to mentally account for the money you’ve spent if you don’t actually ‘feel’ each purchase.
… but there are tools to track your finances.
Of course, it’s easiest to see money leave your wallet when you pay with cash, but in an increasingly digital world, only using paper currency isn’t realistic. Still, you should make sure that you ‘feel’ each decision you make. “People need to feel that their efforts are paying off,” Ariely explains. “So how do we build this in?”
He cites a study he conducted where Kenyan families living in poverty were given coins to track their savings contributions — tokens with no monetary value, just a symbol of their good decision-making. These coins were more effective than monetary incentives or reminders to get people to save.
The lesson, according to Ariely, is that if some of the most impoverished people in the world can do it, so can you. Whether it’s using a budgeting app or keeping a spending diary, you need to hold yourself accountable for your finances — ideally in a tangible, visible way.
With reporting by Emily White | written by Jean Chatzky, SavvyMoney.com.