Human beings act rationally to maximize their wealth…at least according to conventional economic theory and the financial models based on it. If you question that, you may be interested in a growing field of study called “behavioral finance” that integrates psychology into economics and finance to try to explain how and why we often behave predictably irrational when it comes to our money. More importantly, it has many real-world implications that can help save you from one of the biggest threats to your financial future: yourself. Here are a few myths about human behavior that could be costing you money:
1) Spending money on luxuries makes you happier.
In our workshops, we talk about various forms of frivolous spending and how much you could save by cutting them out of your life. So why do people spend money on them? The same reason people do most things. They assume all of this spending makes them happier. But indulging doesn’t actually make us much happier.
For example, a study was done on two groups of chocolate lovers. One group was given a piece of chocolate and then told to abstain from chocolate for a week. The second group was encouraged to eat as much chocolate as they liked and were even given 2 lbs. of chocolate. A week later, both groups were given chocolate, but the first group enjoyed it more than the second. The second group had become too habituated to enjoy it as much.
The same thing can happen whenever we spend money on indulgences, whether chocolate or otherwise. Once we become used to something, it doesn’t provide us as much happiness, yet we’re spending more on it. In economics, this is described as the “law of diminishing marginal utility” and in positive psychology as “hedonic adaptation.”
So, what can you do? You don’t have to give up your luxuries completely. Just do them less frequently. You’ll save money and enjoy them even more.
2) You should monitor your investments frequently to make sure they’re doing well.
After all, in most areas of our lives, performance is pretty important. That’s why sports fans obsess over statistics and employers ask job applicants for a resume. While we know there’s no guarantee, we also know that past performance is a pretty good indicator of future performance…except when it comes to investing.
One problem is that markets tend to move in cycles. Remember the dot com and the real estate bubbles? When a particular type of investment is doing well, there’s a tendency for people to pour more money into that investment. When everyone from news anchors to your mother-in-law is talking about how much money is being made, you want a piece of the action.
But what happens when that investment inevitably starts losing value? You might wait it out a little while, but when the bleeding gets too painful, the tendency is to stop it by getting your money out or at least not putting any more in. Of course, that means you also miss the eventual recovery and turn a temporary loss into a permanent one.
Do you get back in when the investment starts to recover? Typically, people want to wait it out a little and see if it’s real. The problem is that markets rarely move in straight lines, so there are lots of bumps along the way. Once it does rise for a while, the investment is likely nearing another peak, and the “greed, hope, and fear cycle” repeats itself. This is called “herd behavior” in behavioral finance.
What if a fund isn’t doing as well as others in its category? Many financial advisors will cite this as a reason to change funds but the evidence shows that top performing funds don’t generally continue to outperform. In fact, they don’t tend to do any better than the worst performers. A much better predictor of future performance when comparing similar funds is low fees.
So, what to do? Legendary investor Jack Bogle once said “Don’t even peek at your own account, don’t open those 401(k) statements” and called it “one of the greatest rules for investing ever made.” That’s a little drastic, but you see the point. If and when you do look at your account, it should only be to make sure your portfolio is still appropriate for your goals and risk tolerance, re-balance it if necessary, and look for opportunities to reduce fees, trading costs, and taxes. You might even want to do what institutions do in managing their money and put this all in writing in advance.
3) The best way to change behavior is by making small changes to avoid hardship.
The standard approach in financial planning and education is to emphasize the danger of running out of money and the need to make small changes that can lead to significant results in the long run. There is an argument for this. Small changes like saving a little more each day can be more manageable for many people than trying to cut your spending more dramatically all at once, and the fear of having to eat cat food in retirement can be a powerful motivator.
However, a medical study from decades ago provides an alternative approach that might be more effective. In response to the frustrating facts that about 90% of heart surgery patients typically abandon lifestyle changes after just 2 years, and two-thirds of patients prescribed statin drugs stop taking them in a year, Dr. Dean Ornish ran a trial program in which patients with severely clogged arteries were encouraged to quit smoking and adopt a vegetarian diet. The program lasted for only a year, but 77% of patients maintained the lifestyle changes after 3 years.
How did Ornish do it? He claimed that one key factor was a focus on the positive impact of how being healthy would make them feel better rather than a focus on the negative aspect of avoiding death, which often just led to denial. The other was advocating radical changes in behavior that would lead to quicker results, which would help motivate them to continue, rather than more modest changes that still made them feel deprived without the satisfaction of seeing improvement.
In the same way, it may be beneficial for you to start with a positive vision of what you’d like your money to do for you. Then commit to making significant changes that can show quick results, whether it’s paying down your debt or building up savings. The motivating effect of accomplishment is why personal finance author and radio show host Dave Ramsey recommends that people pay off the smallest credit card balances first rather than the ones with the highest interest rates even though the latter approach would save them more interest. Like the best diet, the best financial strategy is the one you can stick with.
Like most myths, each of these myths does have some truth to them. But because of human psychology, following them can get you into financial trouble. So, stop spending on luxuries and checking your investments every day and start visualizing your positive goals and taking big steps to make them happen. When you put it that way, it just seems like common sense, and that’s fundamentally what behavioral finance is all about.
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