Does Your Brain Get in the Way of Savvy Money Decisions?
When it comes to money, many people make bad decisions. That is not because contributing to a 401(k) requires a PhD economy, it is often because the human brain is hard-wired to prioritize short-term money gains Vs long-term benefits.
“Traditional economic theory suggests that investors are rational decision-makers, carefully weighing all available information to make choices that result in the best possible outcome,” a Legg Mason report on behavioral finance explained.
Years of behavioral economic research have shown that that is Untrue.
Below are a few ways the your brain trips you up and some tips to help you avoid falling into these cognitive traps, as follows;
People procrastinate: One of the most significant psychological factors impeding people from achieving their investment, savings and retirement goals is inertia. There are various ways inertia, aka the status quo bias manifests itself. It can be as simple as keeping the same cable plan that costs $120 a month even though a competitor cable provider has a similar plan for $100.
Saving in a 401(k) plan is another big one: Studies have found that despite being given the opportunity to enroll in a 401(k), with an employer match, employees tend to be passive. Procrastination sets in; it’s much easier to just imagine doing the right thing in the future. Many more employees say they plan to take action and enroll than actually do.
That is why more companies have found success with automatic enrollment: In one company that adopted automatic enrollment, when employees 1st become eligible for the savings plan, they are automatically enrolled unless they opt out, 401(k) participation rates for new workers increased from 49% to 86%.
A Big Q: So how can you overcome your tendency to do nothing?
The Big A: Automate as many aspects of your finances as you can. Set up automatic bill pay for recurring bills. Save in a 401(k) plan if you have one and see if your plan offers an auto-increase feature. Another way to get motivated is to imagine life 20 or 30 years from now. A study by 2 researchers found that people shown vivid images of their older selves, where they looked 68 or 70 anni, were more likely to make decisions that favored long-term rewards.
Fear of Loss: Loss aversion is the tendency to avoid accepting the reality of losing money. That means, you just cannot bear to admit you made a mistake. and it’s something that should be familiar to investors who find themselves holding onto a loser stock.
“Psychologically speaking, the pain of losing $100 is approximately twice as great as the pleasure of winning the same amount,” Shlomo Benartzi, a behavioral economist at UCLA Anderson School of Management, wrote in a report for Allianz Global Investors, Mr. Benartzi is also chief behavioral economist at Allianz. We’ll spare you the evolutionary reasons for humans’ tendency for loss aversion, but suffice it to say it is a very expensive and painful trait.
Selling a losing stock is painful, so many investors just avoid a short-term loss, often at the expense of longer-term goals. it. And at the same time people often sell winning stocks too soon because it realizes a gain, and who does not like that? The mistake here is looking at your investments in separate pieces rather than as a whole.
A Big Q 2: Is it possible to get over this bias?
Richard Thaler, behavioral economist at the University of Chicago Booth School of Business and author of the book “Nudge,” suggests that retirement savers, especially those who have a long time horizon should invest in a globally diversified portfolio of stocks, “and then scrupulously avoid reading financial news articles or, even worse, watching financial news networks aka Noise. Paying attention day-to-day is damaging to one’s financial and emotional well-being.”
You cannot walk away: It has happened to all of us; You spend money on something and for some reason you do not end up using it. But you do not want to give up on it because you’ve invested all that money. It could be sitting through a movie you hate or continuing to make payments on a car you can no longer afford. It even could be driving 20 miles out of your way to a store to look for a particular pair of jeans and buying something anyway even though the jeans are not there, because you invested time and gas money to get to that store.
In economic terms, a Skunk Coat is an expense that cannot be recovered. This notion of needing “to get our money’s worth” comes into play in a lot of financial decisions.
Companies do it, too: They continue with a project if they have invested a lot of money, effort and time in it, even when continuing is not the smartest thing to do. The best way to deal with a sunk cost is to accept it and move on.
So if you catch yourself in a sunk cost scenario, remind yourself that just because you have already spent a certain amount of money on a thing does not mean you should continue to do so.
Savvy Investors Build-in Diversification and Flexibility