The field of Behavioral Finance is a relatively new one, combining a bit of psychology with economics and personal finance. Researchers in this field have dedicated their careers to understanding why we make the financial decisions we do, and to helping us overcome maladaptive behaviors while taking advantage of positive ones.
In addition, Behavioral Finance can help you learn not only what you should do, but how to do it… and why. The following four lessons have emerged to teach us how to better spend and save our money.
Stop thinking in the short term. Research has shown that we experience great difficulty in imagining ourselves in the distant future. Most of us can think of what we want to do this summer, or even picture ourselves in five years, but ask someone to picture themselves in twenty years and they won’t be able to do it. It’s an interesting quirk of the human brain that really short-circuits our ability to plan for retirement, because who wants to save for a life they can barely even envision?
Researchers also discovered that merely looking at a photo of themselves, digitally altered to look much older, helped study participants to accept the inevitable. If you can’t access digitally aged photos, try creating your own “doses of reality” that work for you. The point is to make the future feel more real, so that you can plan for it.
Resist the thrill of immediate gratification. Immediate gratification is another common setback with regard to financial planning. You can circumvent this process by making a plan for extra cash before you ever receive it. Ask yourself how you would spend a windfall, such as an inheritance or large tax refund, and commit to this plan in the event this situation actually arises in the future. It’s easier to follow through on a plan when you’ve decided upon it well in advance.
Take advantage of this weakness. Our resistance to change is often cited as a weakness in human psychology, but you can harness it to benefit you. Once you’ve signed up for automatic contributions to a retirement account, for example, you will be more likely to stick with the decision in the future. Few people enjoy the necessary steps required to undo a previous decision.
Overcome the fear of loss. In the human brain, fear is twice as motivating as hope. So translated into financial decisions, we’re more likely to make decisions out of fear of losing money, than hope of gaining it. That’s a terrific protective instinct that you should definitely tap at times. On the other hand, giving into that fear all of the time might cost you some valuable opportunities at growth. Learning to balance your fear of loss with hope of gain is the one major key to making responsible investment decisions.
On that note, give us a call to discuss your portfolio. We can help you overcome normal fears, while keeping the reasonable ones intact.