Why Smart People Make Bad Financial Decisions. Part 1

Welcome to the DailyKobo article series on ‘Why Smart People Make Bad Financial Decisions’. In this series, we will be exploring some common financial decisions we make which aren’t in our best interest. But rather than discussing financial techniques, we will be focusing directly on behavioral issues, particularly the traps and psychological biases that even people who are good at high levels of reasoning and memorization (i.e. “smart” people) tend to fall into.

We strongly believe that identifying the psychological causes of our bad financial decisions would empower us to make the behavioral changes that are required to better manage the money we earn and effectively build wealth for the future.

 

 

PROBLEM: WHY MANY OF US SPEND IMPULSIVELY TO THE DETRIMENT OF OUR FUTURE SELVES

In the late 1960s, Professor Walter Mischel, conducted an experiment which involved children being offered a choice between one marshmallow, provided immediately, or two marshmallows which they could have if they waited 15 minutes without eating the first marshmallow.

On average, the children held out for no more than three minutes, although about 30% of the children lasted the full 15 minutes, and were rewarded with two marshmallows.

In later years, Mischel found that the children least able to defer gratification were the ones most prone to poor academic achievement and with the least capacity to plan and think ahead. The ability to defer gratification was not a result of innate IQ or intelligence, but simply because of self-control.

 

The application of self control in our personal finances is something that a lot of us find difficult to do today. The lack of self control or inability to defer gratification usually takes the form of spending impulsively (even when we promised to save more) or dipping into our savings (“borrowing from ourselves”).

These impulsive moments seem to plague many of us to varying degrees, which then begs the question - what is their underlying cause? The answer to this question is - Present Bias.

 

WHY WE TEND TO SPEND IMPULSIVELY


Present bias refers the tendency for people to have a stronger preference for more immediate payoffs relative to later payoffs. In other words, it occurs when we place greater value on things/income received in the present than the same (or even more) things/income to be received in the future.

Present bias is usually strongest during our ‘hot states’ such as hunger or strong emotions (sadness, anger, happiness, etc). These hot states can seriously affect our decision-making in ways that are not in our long-term interest because temporary - ‘in the moment’ - emotions can have a distorting effect on our behavior and result in circumstances that we may end up regretting.

 

Let’s take the example of Peter - Peter is a 23 year old software developer who earns a monthly salary of ₦150,000 and has a savings goal of ₦300,000; Peter aims to achieve his savings goal by saving ₦60,000 every month for 5 months.

Now, Peter is a massive Real Madrid fan and one fateful day, while watching football in the third month of his savings goal, an advert comes on promoting the launch of the new Real Madrid jersey which he could easily buy online.

Peter, at this point, is awe struck. He has never seen anything so beautiful in his life, and all he can think about is how amazing that jersey will look on him. Unfortunately, however, the jersey costs ₦40,000, which Peter can’t afford without dipping into his savings. So he ‘borrows’ ₦40,000 from his savings to buy the jersey, promising to make up for it later.

 

The example above highlights how we sometimes fall under the present bias; let’s take a look at the steps involved:

1) Peter saw an advertisement which evoked strong emotions in him
2) The strong emotions or ‘hot state’ caused him to make a present bias decision
3) That decision then led to a disruption in the flow of his savings goal which Peter may regret in the future.

As you can see, there are a couple of steps that led to the final bad decision which Peter made. So what steps could Peter have taken to overcome the present bias and avoid that bad financial decision?

 

HOW TO OVERCOME PRESENT BIAS

1. Monitor your urges

The decision Peter made in the example above started with the advert which evoked an emotion and incited his urges. We all experience internal and/or external urges before we succumb to present bias and it’s important that we monitor our urges, if we want to overcome present bias.

You can monitor your urges by keeping a little piece of paper or using your phone, and noting every time you get the urge. This helps you to become more conscious of the urge, which is usually something you don’t even notice. Different symptoms can appear, such as faster breathing or a faster heart rate, when we have the urge. By becoming more aware of the changes in our body, we can begin to get the urges under control.

 

2. Create a 30 day wait list
In this step, you'll need to challenge yourself with this spending rule: Don't buy anything (apart from necessities) until a 30-day waiting period has passed. The whole point of this rule is to increase the amount of time between you feeling any urges and you making a financial decision.
Put a 30-day list on your mirror or work desk, and when you have the urge to buy something, put it on the list with today’s date. After a month has passed, you can buy the item. Many times the urge will have passed and you can just cross the item off the list. This works if you stick to your rule. The only exceptions would be groceries and other similar necessities.

 

3. Plan your purchase

Now, if the thing you want to buy is still a pressing need as you approach the end of your 30 day waiting period, then you'll need to plan towards it, save for it, shop around, and even see if you can get it for free. Going through this process ensures that your purchases are more deliberate and less impulsive. Plan ahead for birthday and Christmas gifts, and other large purchases that you know are coming up in the month ahead. By planning ahead, you would be able to make allowances for your purchase without disrupting your financial goals.

 

If you enjoyed or learned anything from this post, please like it, share it and leave a comment! For more DailyKobo advice, click here to subscribe to our newsletter and don't be afraid to get in touch. For more information and updates follow us on TwitterInstagramLinkedIn and Like our Page on Facebook!

One Response

  1. Tolu 6 months ago

Add Comment

This site uses Akismet to reduce spam. Learn how your comment data is processed.