Even when we attempt to do our best thinking, our choices can backfire. Nowhere is this as impactful as your financial decisions. In fact, there is a dedicated sector of finance called behavioral finance.
This addresses why so many of us make irrational and systematic errors with money that are void of logic and soundness. It has to do with our cognitive biases. We do what we do, then rationalize it.
Are you wrestling with a facet of your money management that is compromising your financial health? It’s the small stuff that catches you unaware, but it can add up to a lot.
Here are five ways our choices may backfire because of cognitive biases and what to do about it:
1. Mental accounting. If you treat a windfall differently from your regular income, such as an inheritance from a grandparent or a large IRS return, then you’re guilty of mental accounting. This refers to the different values we may place on money based on how we acquire it. For example, a tax return can be seen as an unexpected surplus, when in fact, it’s our money in the first place!
And unfortunately, in many cases people will indulge, feeling that the unexpected doesn’t happen often. Errors such as opening a low interest-bearing account while having high credit card balances is one example. Or purchasing a new car and discovering later on how much it really costs. Treat all money the same. Be sure that if you receive unexpected money that you review your financial goals and consider how this can help you to meet them.
2. Sunk cost fallacy. Throwing good money after bad sums up this bias. The more we spend on something, the less we’re likely to let it go. This pertains to things that no longer serve us. Do you have a storage full of unused purchases from a past life that you feel are too valuable to throw away? Are you suffering from home or garage clutter because of the same?
Sunk cost fallacy says we feel guilty about ridding ourselves of what we feel was a costly purchase but we no longer use. If you no longer use it, give it away. This will save your sanity and your checkbook, especially if you are renting space for these items.
3. Retail therapy. This one is particularly tempting; another way to describe it is impulse shopping. “I work hard; I deserve this,” is a phrase one hears often in conjunction with making a sudden and unpremeditated purchase. The advice many give is to “sleep on it for 24 hours.” But you can do more to get out in front of this dangerous behavior by asking yourself how you’re feeling before you enter a store (or the Amazon website!).
If you’re bored, restless, lonely or experiencing any feeling that leaves you empty, take caution. You are vulnerable to impulse shopping. Instead, once you have identified your emotion, pick a healthier way to deal with it. This will save money and a lot of closet space taken up by shirts you’ll never wear.
4. Loss aversion. Do you panic when the stock market goes down? Do you tend to sell the positions in your portfolio so you don’t “lose it all”? This strategy will minimize the returns that you could otherwise enjoy. Work with a responsible wealth advisor who can guide you.
The advice here is to watch the market less. You aren’t abdicating your responsibility by working with someone who oversees your funds, and you should read your monthly statements and meet regularly with your advisor. However, if you are a market “stalker” and this causes panic, back away slowly and allow your professional to manage the portfolio for you.
5. Sinkhole behavior. Have you made a choice that has backfired leaving you feeling paralyzed and embarrassed? Get past it and take action. Do what you can to remedy or redirect the situation by reaching out for help.
And reach out for the right kind of help. Don’t take advice from a neighbor or someone who tells you they once had the same experience. Get help from the right kind of advisor who can look at your situation and the complete picture. They’re best suited to guide you back into the sunlight.
When a choice you have made with your finances backfires, recognize this as a pivot point to help you reassess your money behaviors so that you can redirect and move forward. Your future will thank you.
Patti Cotton works with executives, business owners, and their companies, to elevate and support leadership at all levels. Her client roster includes privately-owned businesses and such entities as Bank of America, Boeing, Coca-Cola, Harvard University, Sysco, Edward Jones, Morgan Stanley and the Girl Scouts of America. Patti@PattiCotton.com.
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