Behavioral finance involves biases towards money. These biases impact how you think, feel, behave and make financial decisions. We may not realize these biases, nor understand why we decide what we decide when making decisions. Biases are often formed based on prior life experiences.
Let me provide you with two examples of how life experiences can impact biases. Imagine a person who had lost a key family member (or multiple family members) due to premature death. Maybe their father passed away when they were only 8 years old. Or perhaps a person watched their parents skimp and save their entire life preparing for retirement only to get cancer in their early 60’s and never see retirement. How would that impact a person’s view on money and financial decision making?
Now compare that to somebody who grew up without money in a household that always struggled to make ends meet. Maybe Mom and Dad each worked around the clock and were always stressed about how to put food on the table, pay the utilities and whenever they had money left over, they blew it on lottery tickets and the casino. Eventually Mom and Dad got to retirement age and are forced to live on cat food and macaroni and cheese. How would that impact a person’s view on money and financial decision making?
Biases lead to assumptions and beliefs. But many times the assumptions and beliefs turn out to be totally untrue or not accurate. That is when conflict arises because the person has to come to grips with an awkward conflict in their life. How did they end up where they did when they didn’t see it coming? Their version of the future in their head somehow didn’t line up with the future as it actually played out which had consequences and ramifications.
If a person lost loved ones early in life or had a dramatic life scare in their own life, it is not uncommon to feel the fragility of life. This leads to behaviors along the lines of “Hey, carpe diem! Live for the day!” Why plan for a tomorrow that is so uncertain anyway? All you have is today so maximize the present at the expense of the uncertain future.
If a person grew up with very stressful financial conditions, perhaps their biases lead them to overcompensate on savings. We see this with older folks who lived through the depression as children. Their life experiences taught them that hoarding is the key to survival and that anything you have can be taken away if you don’t plan carefully. No emergency fund is ever large enough and you should only spend money if it is absolutely necessary. Frivolous or luxury purchases are only for the insane.
You can imagine any number of scenarios that would impact our biases based on life experiences. The breakthrough occurs when you recognize that not only are you biased but when the biases and assumptions don’t line up with reality because your beliefs don’t line up with reality. Here are 3 steps to uncovering your biases on finances;
- Acknowledge that you have financial biases. Sounds redundant but if you want to uncover your biases then you have to be open to the idea that you actually have some to begin with. To assume that your brain is a computer that only runs pre-programmed algorithms with no emotions, feelings or memories is completely false (unless you really are a cyborg). Then I stand corrected.
- Write down or type out your beliefs about money. You have beliefs about money that are completely individualized and based on your own experiences. These beliefs lead to assumptions and bias which impact your decision making. Maybe you believe in saving money. Maybe you believe that you are too young to save money or that you should only save money when you make a certain amount. Maybe you believe that stocks will always go straight to the moon or that real estate is a stupid investment. Maybe you believe that early retirement is possible. Maybe you believe that retirement is never going to be possible. These are your beliefs that are individualized. This only would become clear if we did this exercise with 20, 50 or 100 people in a room and then we compared and contrasted everybody’s beliefs. We would quickly conclude that people have different financial beliefs.
- Challenge your own beliefs. Once you have a list of beliefs (that lead to assumptions and biases) I want you to start challenging these. Take any belief that you have and imagine if the opposite could be true in certain conditions. Maybe you believe that a carpe diem attitude is the key to happiness. Now imagine (or seek out a real situation) where someone older is really struggling financially to make ends meet. Maybe they can’t afford food, or medicine, or heat. How would you feel if you were in their shoes? How do you know you aren’t taking the same road that they traveled? Maybe you believe that saving every last nickel of your paycheck is the only way to navigate life. Imagine if you found out that you had terminal cancer tomorrow. How would you feel about having the money you have (maybe you would feel good because your family would be taken care of?) Maybe you would feel bad because you didn’t live your life because you were always worried about not having enough money. You may find that your beliefs, assumptions and biases don’t match reality.
The point of this exercise is to uncover your biases and question if they are adding real value to your life. You have to factor in your current life and then your future life if you continue along the same path (with the same biases). If you think the stock market is going to go straight to the moon over the next 30 years, what does that mean to you? What if it doesn’t? What would that mean to your life? Would you alter your investment approach? Would you do something else with your life?
Only through serious self-reflection can we determine if we are acting irrational about money in the context of our own lives. Sometimes it takes another person (like a friend, family member or financial advisor) to say, “Hey buddy, you have some strong biases that may not be in your own self-interest but you aren’t recognizing how these are leading you to make bad decisions over and over again. The goal of this is to try and maximize our own happiness over the totality of our lifetimes (not just the present or the future.)