Behavioral psychology and personal finance
This is the first article in our behavioral psychology series by Jonathan Walker, Co-Author of Anchors, Ostriches, and a HotPair of Scissors: Navigating Human Behavior as a Financial Professional. In this series Jonathan will help you understand how your brain deals with personal finances. Understanding these principles will help you manage your money and possibly avoid common but costly mistakes. Here is the full series:
- How to recruit your brain to help with better personal finances
- When being hot can hurt your personal finances
- How doing nothing can blow up your personal finances
- How to use mental accounting to improve your personal finances
- How too many choices can ruin your personal finances
- How anchoring can hurt your personal finances
- How an ostrich can destroy your personal finances
How to recruit your brain to help with personal finances
Isn’t it about time you recruited your brain to help you improve your personal finances? Too often, our brains are working against us just as often as it is working with us. Our brains are functioning behind the scenes in ways that we are often not aware of. If we become more aware of what it is doing, we can make sure that it is helping us make progress instead of being part of the problem.
All of this goes back to the idea of behavioral psychology. Behavioral psychology is a branch of psychology that focuses on understanding how human behavior is shaped by environmental factors, cognitive processes, and social interactions. It explores the influence of biases, emotions, and cognitive shortcuts on decision-making, aiming to explain and predict behavior patterns through empirical research and experimentation.
The study of how our behavioral psychology affects our financial life is often called behavioral economics. It’s essentially the branch of economics that isn’t as “rational” as the classical economists would like it to be. Why? Because we’re human, and humans aren’t always rational.
Here are some key ways in which behavioral psychology influences our financial decisions:
Behavioral psychology highlights the presence of cognitive biases, such as loss aversion, confirmation bias, and anchoring, which can distort our financial decision-making. These biases can lead to irrational behaviors, such as holding onto losing investments, seeking information that confirms our preconceived notions, or being overly influenced by initial reference points. Being aware of these biases can help us make more objective financial choices.
Our emotions play a crucial role in shaping our financial decisions. Behavioral psychology recognizes that emotions like fear, greed, and euphoria can drive impulsive actions, such as panic selling during market downturns or overspending during periods of euphoria. Understanding the impact of emotions on financial choices allows us to manage our emotional states and make more rational and balanced decisions.
Behavioral psychology reveals that individuals often categorize and assign different values to money based on mental accounts. This can lead to suboptimal financial decisions, such as treating windfall gains less cautiously than earned income or compartmentalizing spending based on the source of funds. Recognizing mental accounting biases can help us develop a more holistic and consistent approach to managing our finances.
Present bias and delayed gratification
Behavioral psychology highlights the tendency for individuals to prioritize immediate rewards over long-term financial goals. This present bias can lead to excessive spending, neglecting savings, and insufficient retirement planning. Recognizing this bias can help us develop strategies, such as automating savings and visualizing long-term goals, to counteract the allure of instant gratification and prioritize long-term financial well-being.
Behavioral psychology emphasizes the impact of social norms and peer influence on our financial behaviors. We tend to compare ourselves with others and conform to societal expectations, even in financial matters. This can lead to overspending to keep up with others’ lifestyles or making investment choices based on the recommendations of friends or family. Understanding social influence allows us to make more independent and objective financial decisions based on our own circumstances and goals.
Nudges and behavioral interventions
Behavioral psychology informs the use of nudges and behavioral interventions to steer individuals towards positive financial behaviors. Techniques such as setting defaults, framing choices, and providing feedback can influence decision-making in a desired direction. These interventions can help individuals save more, reduce debt, and make informed financial choices.
By recognizing the role of behavioral psychology in our financial decisions, we can better understand the biases, emotions, and social influences that impact our choices. This awareness empowers us to make more rational, informed, and goal-aligned financial decisions, leading to improved financial well-being in the long run.