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Economic research has long assumed that human beings are rational decision makers who optimize their resources based on the information available to them. However, new research continues to uncover evidence that is in fact not the case.
Economic research has long assumed that human beings are rational decision makers who optimize their resources based on the information available to them. However, new research continues to uncover evidence that is in fact not the case. The reality is that human beings are emotional creatures that can easily develop behavioral biases which can negativity effect how we manage our finances. Let’s look at how the human mind and some of these biases can derail even the best laid financial plans.
The 2 systems of the human mind
While humans only have one literal brain, new research has shown that we seem to have two minds. Psychologist, Daniel Kahmen has proposed that we have two different modes of thinking that operate in parallel and even sometimes conflict with one another.
The first is system 1 which I the fast and automatic portion of our brain, that takes information round us to keep us alive and functioning in our environment.
The second is system 2 which is responsible for what we typically associate with our “thinking” efforts. This is the slow and methodical approach that uses complex mathematical calculations to make decisions.
While financial planning and decision making is a system 2 activity by nature it is important to know how operate together and can help or hurt us.
One example is the pay yourself first strategy in which money id automatically goes into a savings or investment account. This picots something which would require system 2 into a system 1 default. Using system 2 could lead to us over analyzing this decision and skipping one or may payments.
Another example is how often investors sell at the market “bottom”. It is not only because they are scared but because the nature of volatile markets can literally exhaust and deplete system 2. System 1 then kicks in and reduces our self-control and willpower to resist making impulsive portfolio changes.
The Social Proof Phenomenon
Also known as “herd behavior”, social proof can potentially cause humans to move in the wrong direction. In the context of financial planning, it can be portrayed in the “keeping up with the Joneses mentality”. This is where people access where they are spending too much or saving too little not off their personal situation, but by what their neighbors are doing. Since other people buy bigger houses, nicer cars, and fancier clothes it must be the reasonable thing to do.
Social proof is not always negative though. After all, the herd mentality tended to be a good thing for self-preservation. The social dynamic leads us to validate our behavior by looking at those around us and feeling accountable to them. This has been seen in various helps groups such as alcoholics anonymous. People using the buddy system tend to follow through on commitments in order to be accepted by others.
In the financial planning world, it has become one of the main benefits of working with a financial advisor. Apart from the obvious reasons you would engage with an advisor they can also prove thier value by acting as an accountability partner for your financial goals.
The End-Of History Illusion
A 2013 study Quidbach, Gilbert, and Wilson found that most people are actually very bad at predating what will make them happy in the future. This illusion has significant impact on financial planning. As planners we try to get clients to focus on planning for the long term by acting in the short term.
The reality is that it can be very difficult to plan for a life that you cannot predict. For example, planning to retire and buy a home in X city in X number of years. Instead, focus on building your retirement assets to be able to retire and worry about the specifics later.
Conclusion
As financial planners we must be aware of certain psychological factors that play a role in how people view their finances. Which is why one of our main value propositions is acting as a behavioral coach for our clients. If you are looking to add an “accountability partner” feel free to schedule a call with us here.
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