One thing I have learned during the course of my eighteen years in the financial industry is that a person’s view on money is like a fingerprint; no two views are exactly the same. They may have similar values, they may invest using similar methods but everyone treats money slightly differently from the next person. The question to ask is “What is your Behavioural Finance?”
Here are some of the typical behavioral traits people exhibit when it comes to finances:
a] Mental Accounting
The majority of people prepare a monthly budget and allocate certain parts of their pay cheque to certain bills. This “preparation” is slightly different with mental accounting. Mental accounting is the tendency for people to designate particular money for a specific purpose, without consideration for the big picture in terms of practicality. For example, a person can split their money and treat each portion differently, depending on which “account” it’s in. So, money in a savings account is treated differently than money meant for debt repayment. That is, even if a savings account is paying 1% pa in interest and their car loan is costing 7.5% pa in interest, the money they allocate to each “pot” they deem as equal because each “pot” of money has been designated for a purpose.
Budgeting is an excellent way of money management, but mental accounting can be a detriment to your overall financial goals. If your savings account is paying little in interest but you are paying a higher rate of interest on a loan, common sense would dictate tackling paying off the debt because it is costing you more money. Thinking of the “big picture” when it comes to your finances and applying logic will certainly help towards financial goals.
b] Herd Behaviour
Ever had a friend tell you about a “hot” stock that they made a lot of money investing into? It is quite common for people to follow the crowds; however for most people they never truly get the desired results. The reality is this, by the time that “hot” stock tip gets to you, the average investor, the run is over and you will be left owning an overvalued stock.
Making decisions based upon your goals should be your only concern. What your friends are or are not doing is irrelevant––they don’t pay your bills and they are not going to pay for your retirement. Breaking the herd mentality is one of the best steps you can take towards improving your own finances.
c] Anchoring
This is the idea that you attach your spending level to a specific reference. I read an article several years ago about the sociology of purchasing wine in a store versus purchasing wine in a restaurant [yes, articles are written about this topic]. You might assume that a “good” bottle of wine should cost a certain amount of money. You might note that the most expensive wine on a restaurant’s list costs $100 a bottle. Normally, you would only spend $25 on a bottle of wine, however, you are now anchored to the idea that “the best” costs $100, and you don’t want to spend “only” $25. Instead, you “compromise” on a $45 bottle of wine. You spent more than you wanted because of that anchor.
It’s all about retraining the brain. Apply common sense and logic to your finances. Anchoring onto something that is going to stretch your finances doesn’t make sense especially if it is a want and not a need.
d] Belief in Being “Above Average”
How many times have you come across a person who is intellectually book smart and knows lots of facts, but has absolutely no common sense? They could recite the periodic table but ask them how much they are contributing to their company pension plan and you probably get a blank stare. Intelligence is the capacity to learn, common sense is having sound practical judgement. One of the hardest things to achieve for a person who “thinks” they are above average intelligence is to recognise they too have shortfalls and to ask for help when needed. So who’s smarter––the one that learns the facts or the one that knows how to apply the information?
It is important to put egos’ aside, identify areas you may not be that savvy on and locate a resource to fill the gap. This could be by using an investor advisor to help guide you through investing or by utilising a budgeting tool that keeps you on track of your monthly spending.
At the end of the day behavioral finance is about identifying your own traits and how you manage your money. By being aware of them, and adjusting your own behavior you should be able to apply practical and rational concepts to your finances.
Carla Seely is the Vice President of Pension and Investments at Freisenbruch. If you would like any further details, please contact her at cseely@fmgroup.bm or call +1 441 297 8686.