Have you ever struggled with determining the best investment strategy or deciding how much you should save for retirement? You’re not alone. Financial decision-making can be challenging for anyone. However, these decisions are essential to your life.
Understanding how psychology plays a role in financial decision-making can help you make better choices and manage your money more effectively. So let’s dive in and explore some ideas together.
Why Is It So Hard to Make Financial Decisions in the First Place?
First, let’s take a look at some reasons why making financial decisions can be challenging:
- Money is a complex and emotional topic—you may have deeply ingrained beliefs and fears around money that can influence your decisions on how you spend, save, or invest your money. Seeking professional financial advice and support can help you develop healthier attitudes and habits around money and empower you to maximize your resources.
- Financial choices often involve trade-offs, and weighing the pros and cons of different options can be challenging. With careful consideration and planning, you can make more informed decisions that align with your values and help you achieve your financial goals.
- You may not have received enough financial education or guidance to feel confident in your financial decision-making. The key is to start learning and take action to improve your financial situation.
Why Are We Irrational When It Comes to Financial Decisions?
Have you ever made a financial decision that, in hindsight, didn’t quite make sense? Maybe you splurged on a big-ticket item when you should’ve been saving for a rainy day or passed up a great investment opportunity because you were feeling risk-averse. It’s easy to beat yourself up over these types of decisions. Still, the truth is, we can all be susceptible to irrational behavior regarding our finances.
Let’s look at some of the causes of irrational financial behaviors.
1. Influenced by Biases
It is easy to be influenced by behavioral biases such as anchoring, loss aversion, and overconfidence.
Anchoring
Anchoring can cause you to rely too heavily on the first piece of information you receive. Once you “anchor” to that information, it can be challenging to see things objectively. For example, let’s say you are purchasing a car and the dealer tells you the price is $35,000. You may be anchored to that price (even if it’s above the car’s value) and have difficulty negotiating a lower price.
As a result, anchoring can lead to poor financial decisions because it can prevent you from seeking out better options.
Loss Aversion
Did you know that the pain of losing can be more powerful than the joy of gaining? Some studies have shown that people experience the pain of losing something nearly twice as much as the pleasure of gaining something. For example, if you invest in a stock and it loses value, you may feel the loss more strongly than the pleasure you would feel if the stock increased in value by the same amount.
Loss aversion can impact your decision-making and cause you to make poor investment decisions and miss out on potential financial gains (you don’t want that!).
Overconfidence
Do you feel like you can make all of your financial decisions independently? Overconfidence bias can lead you to overestimate your abilities in the financial market and can result in financial losses and missed opportunities. According to a 2020 International Journal of Management review, overconfident individual investors often don’t manage and control risk appropriately. As an experienced financial advisor, I can help you make the best financial decisions for your situation.
It’s essential to be aware of these biases. With awareness, you can be better informed and avoid the influences of behavioral biases on your financial decision-making.
2. Not Looking Long-Term
You may be prone to short-term thinking and discount the long-term benefits of certain decisions. Spending money on impulse purchases or experiences rather than saving for retirement or investing in the future can become a problem. The decisions you make today can have a significant impact on your financial outcomes in the future.
To overcome short-term thinking, you should focus on the big picture and consider the long-term benefits of your financial decisions. Setting long-term financial goals, such as saving for retirement or paying off debt, and breaking them down into smaller, achievable steps can be helpful.
3. Influenced by Social Pressures or Comparisons to Others
Social pressures and comparisons to others can also significantly impact your personal finance decisions. It’s human nature to look to others for social cues and validation, but this can often influence spending and saving behavior.
It’s important to be mindful of the impact of social comparisons on financial decisions. Comparing yourself to others can lead to feelings of inadequacy or envy. It can drive you to make poor financial decisions. By focusing on your goals and values, you can make more informed financial choices that align with your long-term interests.
Make It Easier on Yourself
Now that you understand some of the challenges you can face while making financial decisions, following these three simple steps can help you simplify the decision-making process.
- Have a plan: A plan can help you clarify your financial goals and priorities and make it easier to make decisions that align with your values and goals. A 2020 survey by Hearts & Wallets found that Americans who had a financial plan had increased savings and experienced more confidence in financial decision-making.
- Have a process for reaching your goals: Having a process to follow can help you break down larger decisions into smaller, more manageable steps, reducing your decision fatigue. Sticking to a solid financial plan can be challenging if you don’t have a process to achieve your goals.
- Automating your finances: Automating your savings and investing should be part of your process. It can take the guesswork out of the decision-making and help you avoid making emotional decisions with your money. Automating your finances will help ensure you consistently work toward your financial goals.
Let the Team at Legacy Planning Help You
Financial decision-making can be challenging, especially for high-income earners. So it’s crucial to understand how psychology and emotions can play a significant role in the decisions we make with our money.
At Legacy Planning, we’d like to come alongside you and help you make more informed decisions. To see if we can help make decision-making easier for you, click here to schedule a conversation today.
Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual.
