Did you know, we are not wired to handle money. Dr. Ted Klontz says that our brains haven't received an update in 150,000 years. This makes it easy for us to make money mistakes. But not all money mistakes are the same.
Two Categories of Mistakes
When we make bad money decisions it has to do either with our thoughts or our feelings. Mistakes based on our thoughts are far easier to overcome due to the fact that our emotions are lie deeper inside us than our thoughts do.
Mistakes Based on Thoughts
There are so many mistakes based on thoughts that they've been split up into two buckets; mistakes based on how we hold onto prior beliefs and mistakes based on processing information incorrectly.
Holding On To Beliefs - Expectations matter, and our views of the world matter. Research has shown that we will hold on to our existing beliefs at all costs. We'll ignore or downplay new information that doesn't align with our existing views, we search for information that supports our views, we believe we have control over things we don't and we believe with hindsight that we knew something all along. These kinds of errors can result in us:
throwing good money after bad,
getting caught up in herds,
not learning from previous financial mistakes,
not diversifying our investments, or
trading too much in our investment accounts.
Errors Processing Information - Sometimes our brains just aren't wired for processing the kinds of information we need to process to make good decisions. Unless we've been trained and have excellent will power, we are susceptible to getting tricked. Marketers and advertisers know these tricks very well. That's why they put the "original price" on their prices tags; because they want us to think they are getting a good deal. Just a minute of thinking about that and we'll realize that the item isn't worth their "original price" because if they could sell it at that price, they would. We have a tendency to treat money differently depending on its source, we'll get hung up on the "original price" of an item, hearing options told to us in different ways can change our decisions, and we judge the likelihood of something happening based on how often we see it in our lives. These kinds of errors can result in us:
having investments that aren't fully diversified,
paying more for an item that we should have,
make financial decisions without fully considering all the choices,
thinking we made a good decision when it was the result of good timing, or
jumping into hot investments.
Mistakes Based on Emotions
It's not just our thoughts that influence our money mistakes. Our feelings get in the way, too. These kinds of mistakes come from impulses and having emotional attachments to ideas. These tend to be more difficult to overcome because our emotions are buried deeper in our brains, but that doesn't mean it's impossible. Because of emotional biases we'll avoid losses at the expense of gains, become too confident in our abilities, take the short view instead of the long view, prefer how things are even if things aren't good, or struggle to get rid of something we own because we value it too highly. This can result in us:
invest more (or gamble more) in order to break even,
underestimate the downside of financial decisions,
fail to save enough for the future,
fail to take charge of our financial lives,
hold onto investments too long (e.g. inherited assets, company stock),
not take enough risks with our money, or
attempt to "keep up with the Jones'."
What Can You Do?
One of the best things you can do it learn as much as you can about the ways we make improper financial decisions. Another good option is to run your financial decisions past a trusted advisor (I know that sounds self-serving because of my work at Hagen Financial, but one of the most powerful things you can do is entrust someone who doesn't have your level of emotional attachment).
The mistakes that we make on the thoughts side are easier to overcome. Mistakes that we make based on emotions are rooted deeper, but just being aware of the potential problems we can have can help us make decisions in the future.
Michael Pompian: Behavioral Finance and Wealth Management
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