“Making financial decisions you won’t regret later can prove challenging no matter how rationally you approach them.”- Diane Marra
If you feel overwhelmed and frustrated when you make wrong decisions with your money, you aren’t alone. One of the newer branches of economics, called “behavioral economics,” has confirmed that even disciplined and focused people make irrational decisions about their finances.
Making financial decisions you won’t regret later can prove challenging no matter how rationally you approach them or how well you educate yourself. Behavioral economics is concerned with resolving the disconnect between cut and dry personal financial responsibility and counterproductive, often irrational, choices people make with their money.
Behavioral economists believe that evaluating money behaviors through the lens of science can help create better financial habits and lessen the stress of retirement planning. Gaining more understanding of the thought processes behind your economic behavior allows you to formulate financial decisions that make sense and feel right to you.
According to behavioral economists, human beings tend to make decisions that bring us happiness in the moment rather than optimal decisions for the future.
For example, your choice to use a credit card to pay for a luxury hotel suite rather than pay cash for lesser accommodations has a basis in psychology. As author and behavioral psychologist Dan Ariely says, some of the most analytical thinkers are what he terms “predictably irrational.”
But, says Ariely, brilliant thinkers are quick to acknowledge and find fixes for their irrational behavior.
How can you improve your money decisions?
The first place to begin if you want to understand why you do what you do with your money is discovering your money mindset. This “money personality” is influenced by many things, including where you grew up, how your parents thought about money, personal values, education, and other factors.
Once you have done the necessary work to understand your relationship with money, you can harness that mindset to achieve your financial needs and goals. Sit down with an advisor who is open to the concept of behavioral economics and let them help you with this process.
Decision paralysis is one of the most significant reasons intelligent people make irrational personal and financial choices. An example of decision paralysis is when you walk into a coffee shop and are greeted with a fifty-item menu and all sorts of customization options. This information overload may cause you to take longer than necessary to make a selection, or you will resort to default mode, choosing the first product you see.
Another typical behavior that negatively impacts financial choices is tunneling. Tunneling occurs when you focus too much attention on an emergency situation or immediate need and ignore long-term goals.
A planning fallacy is when a person underestimates how long it will take to complete a task, such as paying off consumer debt or saving for college tuition. A planning fallacy can lead to unrealistic expectations that cause you to become discouraged about the future.
There is a way, however, to beat back these and other self-defeating, irrational money behaviors. Using goal gradient theory, you can break down larger money objectives into smaller, more manageable chunks. For example, when paying off consumer debt, try setting monthly goals in addition to your annual goals. Specialized software exists that helps you utilize goal gradient theory more efficiently and accurately.
Another reset method to consider is mental accounting. Mental accounting is an exercise based on the different values people place on money. These values inform how people organize their cash. For example, some people value money the same regardless of its origins. For these people, money earned at a job has the same value as inherited money. Mental accounting can help you make a conscious decision to treat money differently depending on where it came from and where you want it to go.
The bottom line: Developing greater awareness of your natural decision-making processes will affect your saving and spending and make it easier to improve your financial habits. Start slowly and perhaps concentrate on one behavior a week. Bit by bit, you will see improvements in your relationship with money, leading to better decisions and more financial success.
Investment advisory services offered through Horter Investment Management, LLC, a SEC-Registered Investment Advisor. Horter Investment Management does not provide legal or tax advice. Investment Advisor Representatives of Horter Investment Management may only conduct business with residents of the states and jurisdictions in which they are properly registered or exempt from registration requirements. Insurance and annuity products are sold separately through Diane Marra. Securities transactions for Horter Investment Management clients are placed through E*TRADE Advisor Services, TD Ameritrade and Nationwide Advisory Solutions.
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