The trajectory of one’s life is very much dependent on one’s ability to make good financial decisions. More often than not, our personal circ*mstances are a reflection of our decision-making. And yet, making good choices is sometimes harder than it seems. In this article, we take a closer look at what drives us to make sub-optimal financial decisions.
Emotions: When it comes to behavioural finance, greed and fear are the most referenced culprits of bad decision-making, but they’re not the only emotions that our rational brains are susceptible to. Anger, such as that experienced in an acrimonious divorce, can lead an embittered spouse to make poor financial decisions that can fundamentally affect their financial futures. Feelings of sadness and emptiness are known to drive people to indulge in ‘retail therapy’ in an attempt to fill an emotional void. In the race against the Khumalos, jealousy and envy can cause people to live a lifestyle way beyond their affordability. The link between depression and debt is well-documented as debt can make one feel helpless, hopeless and low on self-esteem. Depression compromises a person’s ability to make clear and rational decisions and, in fact, can lead to lethargy and inaction – which in itself can be a bad decision. Emotions play a much bigger role in our ability to create wealth than most of us tend to acknowledge and, as such, understanding our emotional biases and weaknesses should be an imperative.
Financial fatigue: According to numerous studies, poor people are more likely to make bad financial decisions because they’re compromised by what is termed ‘financial fatigue’. The constant, day-to-day financial struggles experienced by the impoverished impact their psychological resources and can result in poor decision-making. Being heavily indebted can lead people to believe that they’ll never escape their financial struggles – a result of which is that they continue making poor decisions. For example, financial fatigue can lead a heavily indebted person to spend money buying lottery tickets instead of paying off debt. Tired of constantly worrying about money and living hand-to-mouth, those who suffer from financial fatigue are less resilient and more susceptible to bad money decisions.
Lack of self-control: When it comes to wealth creation, self-control can be more important than intelligence. The ability to defer gratification and exercise self-control involves planning ahead to what might be and then weighing it against the opportunity that presents itself in the moment. The ability to plan, weigh up the opportunity costs and delay gratification is a key predictor of success later in life. Sadly, our culture of consumption has resulted in an increase in impulse spending as more and more consumers connect with the pleasure of purchase.
Poor financial literacy: Essential money skills such as budgeting, forecasting and basic money management are very often not taught at home or at school. Not understanding how compound interest can either work for or against you often leaves people consumed by debt and unable to build wealth. Further, a lack of understanding when it comes to investment risk and reward can keep people locked in low-return investments that don’t keep pace with inflation over time.
Biases: Behavioural and cognitive biases can present a real challenge to wealth building as they can affect the way we think and act, causing us to make irrational decisions that are detrimental to our financial security. Cognitive biases are emotional in nature and can affect the way we think and feel whereas, on the other hand, behavioural biases, affect the way we behave in certain circ*mstances. For instance, in support of your belief that cryptocurrency is the best investment, you actively seek out information that supports your view – a form of confirmation bias driven by your emotional need to find evidence that you are correct in your view of crypto. ‘Herding’ is a great example of behavioural bias – a bias that leads investors to follow each other rather than undertake their own research and analysis. Believing mistakenly in ‘safety in numbers’, investors tend to herd together for fear of missing out on an investment opportunity. Relying on the false belief that ‘everyone can’t be wrong’, investors choose to follow the herd rather than get independent and well-researched advice.
Not seeking advice: Not seeking sound, independent financial advice can also lead to poor financial outcomes. In fact, the belief that one can take care of one’s own financial planning, despite the complexities of the task, is an excellent example of over-confidence bias. Over-confidence bias is the tendency people have to be more confident in their own abilities than is objectively reasonable, such as the tendency of some to assume they know more about financial planning than the average financial advisor. In the context of finance, over-confidence is demonstrated on a daily basis by investors who attempt to time the markets despite overwhelming evidence that it is rarely a successful strategy. Whether it’s through over-confidence or lack of trust, not having an advisor who can guide you can result in bad financial decisions being made.
Information overload: The sheer volume of information – and disinformation – makes it difficult to filter through the noise and make sound financial decisions. The number of investment types and options available to would-be investors is extensive, and an information overload can lead to analysis paralysis – being so swamped with so much information that you take no decision at all which, in turn, can serve to compound your financial problems.
In conclusion, poor financial choices often stem from a mix of cognitive and emotional biases, lack of financial education, and external pressures. Understanding these factors is crucial for making informed decisions and avoiding common pitfalls. By recognizing the influence of emotions, seeking reliable financial advice, and cultivating disciplined spending habits, individuals can improve their financial outcomes.
Have a super day.
Sue
