The principles of money are easy to understand. Yet how come there are so many smart, well-educated, industrious people living in the United States, the UK, Canada, and Australia who continue to make disastrous financial choices on an ongoing basis?
Neither ignorance nor indolence is behind that phenomenon. The answer is psychology.
The human brain evolved to help us survive. Not invest. And when we need to reconcile the demands of those two different realms, feelings tend to prevail — often with financially detrimental consequences.
The real reason why people make irrational decisions with money, and what we can do about it, can be found below.
1. Your Brain Treats Financial Loss Like Physical Pain
Here is an interesting discovery made by neurologists: The section of your brain that is triggered when you lose money is the same part of the brain that triggers when you suffer from physical pain.This phenomenon is called loss aversion. It is extremely dangerous and damaging to finances.
Loss aversion which is the main reason why people make irrational decisions with money causes people to:
- Hang on to losing investments for too long thinking they will “recover”
- Get rid of successful investments too soon due to fear of losing profits
- Refuse to invest at all since the risk of losing money is unbearable
- Do panic investing during market crashes that result in permanent losses
2. Following the Crowd
Human beings are highly social animals. In the course of human history, going with the flow has been an instinct that has ensured human survival, if all your peers were running, you did not ask questions.
In modern day financial markets, this translates into herd behavior, which is absolutely financially disastrous and this may be one of the cause why people make irrational decisions with money.
When everyone around you is getting rich on a particular investment, your brain interprets that social signal as safety. In reality, by the time everyone is talking about an investment, the smart money has usually already moved on.
3. We Live for Today and Ignore Tomorrow
Your brain is really, really good at placing value on things that happen immediately and really, really bad at putting value on things that will happen later on. We place value on things that are tangible rather than things that seem to have an abstract concept. This is called present bias, the act of overvaluing immediate rewards while strongly devaluing rewards in the future.
The sad truth is that those decisions that give us the most satisfaction in the moment are the very same ones that are going to hurt us financially down the road this is why people make irrational decisions with money.
4. We Fall in Love With Stories Instead of Facts
The tale in 2006 was one that promised Americans that their real estate would only ever go up in value and that housing prices will never fall in the United States nationally.
There was no doubt that many sensible people believed this tale because the narrative felt right despite the lack of data supporting it. The outcome was a Financial crisis in the USA like never before.
That is how narrative bias affects our decision-making processes. It leads us to base our choices on emotional and social arguments rather than factual information. Narrative bias makes us invest in companies based on stories of hope and promise instead of looking at the numbers and facts. In addition to that, it leads us to listen to financial influencers telling tales and neglect experts who give us accurate and boring numbers. So, narrative bias is one of the cause why people make irrational decisions with money.
The worst thing about these financial tales is that they appear to be based on some truths, making them extremely convincing.
5. We Are Overconfident in Our Own Abilities
Studies carried out in America and Britain showed that virtually all people think that they are better drivers, employees, and even worse, investors than the rest of the population. From a mathematical perspective, this is absolutely not possible. Psychologically, however, it is true for the vast majority.
Overconfidence bias while making investment decisions results in overtrading, which incurs unnecessary expenses and decreases gains. Several studies have shown that the highest performers when it comes to individual investment activities are those who earn much less money than passive investors who only invest in index funds.
6. We Buy Things to Feel Good, Not Because We Need Them
Retail therapy may also be one reason why people make irrational decisions with money. When consumers become stressed, anxious, bored or socially insecure, engaging in shopping activities activates the production of dopamine in the brain. It feels good but comes at a price.
The emotional spending pattern is the most significant factor preventing people from saving money, despite having enough income for comfortable savings. This is not an issue of budget management but a problem of emotional management.
Emotional spending is motivated by Stress, Social Comparison, Identity, Boredom. There is no doubt that the financial cost of emotional spending is immense. Even more significantly, there is the cost of lost opportunities, because each dollar of emotional spending is a dollar that can be invested in the stock market.
7. We Anchor to Irrelevant Numbers
Even when a share was valued at $200 last year and currently trades at $80, most investors consider it undervalued based on their anchoring to the figure of $200. In reality, the initial valuation is totally irrelevant to the value of this security.
In other words, people anchor their decisions to some benchmarks that logically do not affect present value.
8. We Underestimate the Power of Small Decisions Over Time
Another thing to understand before knowing why people make irrational decisions with money, is knowing Sipping $6 coffee might seem like no big deal at the moment. 6×365=$2,190
But that’s how much you’re spending on coffee per year! And by failing to save that money regularly for just one month, you could lose tens of thousands of dollars due to the wonders of compounding over the course of 30 years.
The issue with financial decisions on such scales is the simple fact that they are hard to comprehend and seem insignificant — because, indeed, they are, when viewed in a vacuum. However, our brains are not capable of intuitively understanding compounding growth. As a result of that, people tend to:
- Underestimate the cost of small, regular expenses
- Fail to understand the amazing impact of small, regular investments
- Choose to invest their money in one-off purchases rather than small, regular savings
- Start saving money only when they have a considerable sum to put aside “because otherwise it doesn’t pay off”
However, the very reverse is actually true.
How to Fight Back: Practical Steps to Make Better Money Decisions
After knowing why people make irrational decisions with money, we need to know the steps to make new better decisions. let us discuss them one by one.
- Take a pause before making any major decision involving money — put in place a mandatory 48-hour cooling off period before making any purchase or investment past a particular threshold.
- Rely on facts, not fiction — when analyzing any potential investment, demand the numbers rather than its story.
- Make your saving and investment process automatic — get rid of emotions and make sound money management habitual.
- Learn about cognitive bias — merely knowing that you suffer from such biases makes it less powerful over you.
- Consult a financial advisor — nothing beats an outside view in helping you counter emotional decisions.
- Maintain a financial diary — documenting your money transactions and emotions behind them is an excellent way to become accountable.
- Figure out what is “enough” for you — defining your ideal level of financial success prevents pointless comparisons.
