Why Smart People Sometimes Make Poor Financial Decisions
Everyone wants to make smart financial decisions but unfortunately a lot of the mistakes individuals make are wired into their brains. Think back to when you were a child. Do you remember hearing your parents talking about money (or lack of) or the family finances? What was your experience as a child with money? Did you save or spend every penny you received? There is a relatively new term called “Behavioral Finance” which uses psychology to understand why individuals make the financial decisions they do.
Here are three behaviors to avoid:
- Mental Accounting-Mental accounting is when we separate finances into different buckets. We all do this. For example, you may have funds earmarked to fund different goals-retirement, education and emergency. The problem occurs when you are so focused on these buckets without seeing the overall picture. For example, you are focused on adding to your emergency fund in an account paying 1% but you are carrying a balance on a credit card with an interest rate of 12%. Or, you are contributing to your retirement account each year yet your treat your income tax refund as found money.
- Throwing Good Money After Bad-Throwing good money after bad also known as the Sunk Cost Effect is a bias in which we are unable to ignore what we have already invested in a decision even if we cannot recover the cost. This bias prevents us from making a rational decision based on the situation itself without taking into consideration what we may have already invested. You want to make financial decisions based on what they will produce in the future not how much money you have invested in the past whether it is your car, house, investments, etc.
- Procrastinating on financial decisions-One of the main obstacles to planning effectively for your long-term financial goals is procrastination. We sometimes have a tendency to put off making important financial decisions due to lack of confidence. Typically, the lack of confidence is due to the fear of making a mistake. In this situation, you can easily overcome this obstacle by educating yourself. Enroll in financial classes or workshops. If you need more guidance, consider hiring a financial planning professional.
Are any of these behaviors familiar to you? If so, the good news is by recognizing and understanding these behaviors and biases you can control them and avoid making poor financial decisions that could sabotage your financial future. So the next time you make a financial decision (or not) stop and think-“Am I making this decision based on sound information or am I allowing my biases to get in the way?”