With Valentine’s Day coming up (ahhh, I’m looking forward to my favorite chocolate!), it’s time to talk about our relationship to money. The bogeyman for many people’s relationships is often money, budgeting and investing. For a lot of folks these are scary terms. Unless you’ve got a finance background, or were raised in a family that explicitly talked about saving and investing for the future, making the right financial decisions for today and for retirement can be confusing.
Many of us make money decisions based as much on unconscious as conscious factors, which is our cognitive bias. If you aren’t familiar with the term, a cognitive bias is a preference that is based not on data or rational analysis, but on factors such as individual experiences and emotions. Cognitive bias can impact all sorts of financial decisions, whether to buy or pack our weekday lunches, the neighborhood we live in, to when we start saving for our children’s college education.
Our parents’ relationship with money may have a significant impact on our own relationship with money and influence our own cognitive bias. This can be an anchoring effect – we anchored our core beliefs about money based on our experiences with our parents. We may not be making productive financial decisions because of this effect.
For example, if our parents used credit cards like they were manna from heaven and eagerly sought out the fanciest gadgets/purses/cars, then we may do so, too. The immediate pleasure from the purchases outweigh the long-term negative financial consequences for our parents. They may be uncomfortable with budgeting and may not understand topics like interest rates, financial planning, credit and retirement planning. In a sense, debt becomes another family member. Not anyone’s favorite family member, but nonetheless debt has a permanent place at the dinner table. And, we may mimic these same behaviors to our detriment.
In contrast, we may have observed our parents counting pennies and nickels, and did without for financial security. This approach makes sense for those parents who are struggling to make ends meet and are living paycheck to paycheck. However, as their financial situations improve though promotions, investing or relocations to lower cost of living areas, this drive to excessively renounce pleasures may cause more harm than benefit. Similarly, we may sacrifice in the same ways without much reflection, even if we are in substantially different financial positions. Debt is to be feared and avoided at all costs, like the noxious neighborhood bully.
Another fallacy that some of us may experience is what’s called the ostrich effect. There is a myth that when facing danger, ostriches will bury their heads in the sand rather than face the threat head on. While not true for ostriches, it is true for human beings that we may procrastinate major decisions (whether financial or personal). It can be hard to accept a small loss today for a large gain in the future. A great example is saving of a child’s college education through a 529 plan. Many parents understand the importance of saving for college, but may wait until the child is in high school to start saving, thus missing out on the benefits of compounding.
A related bias to the ostrich effect is the fear of losses. Most of us understand that market volatility is normal and to be expected. Market volatility is typically the wide fluctuations of stock prices in a relatively short period of time. While we all know that we should buy low and sell high, many folks may either become scared when stock prices are dropping and sell at a loss or may want to take advantage of a rising market and pay too much for their stock purchases. In recent studies, investment results have shown that a portfolio’s returns are more dependent on investor behavior rather than fund performance. For tips on how to reduce the emotional impact of market volatility and consistently follow your investment plan, check out this resource.
If you are considering reevaluating your own cognitive bias when it comes to money, here are some questions that may assist you in the process:
- What are your (and your partner/family) 1 year, 5 year, and long-term financial goals?
- Are those goals in sync with the decisions you are making today? (Here is an easy budget tool to help you understand your current financial situation.)
- If your goals and your current financial decisions aren’t in sync, what additional education do you need? Who can help you in the process?
- If they are in sync, what can you do to improve your likelihood of success?
Cognitive bias can be tricky to overcome -- if you have any questions on achieving your financial goals through a financial plan and investments, ACG is here to help.