Why You're Irrational With Money

When it comes to your personal finances, a lot of us know what we should do and still find ourselves making bad financial decisions month to month. Psychological influences and biases affect our decisions. Understanding influences and biases will help you understand the why behind your financial decisions and errors. When you understand why you make irrational decisions, you will check impulses and at make more rational decisions in the future.

Overconfidence

The fascinating thing about learning is that you can always learn more. Some lessons stick for life and some we just forget. However, the one thing our minds don’t do so great at, is realizing the limits to what we can do. This makes us overconfident which means we tend to miss perspective that leads us to make an irrational decision.

Mental Herd Behaviour

Mental Herd Behaviour is the behavior of following other people’s decisions, groups, and actions under the assumption that they have done their research when in reality, we have no way of knowing that unless we ask them. This makes us jump on the bandwagon when it’s much better to keep on your own path.

Emotional Gap

The Emotional Gap will be encountered by all at some point in your life. An emotional gap refers to making decisions based on emotions rather than logic. This can be a rushed decisions because you are stressed, mad, angry, or excited. The emotional gap is one that most new investors fall into a few times before they learn not to o make decisions based on their emotions. For example, FOMO (fear of missing out) will often cause investors to jump into a stock position even when their rational brain see that stocks spike is likely near it's peak. The real problem comes when people have a hard time realizing that their emotions are taking over.

Confirmation Bias

A confirmation bias refers to having a bias for sources that already confirms what you initially believe. For example, imagine a person who believes that dogs are much better animals compared to cats. Whenever this person encounters a person that believes the same statement that dogs are indeed much better animals compared to cats, the person with the confirmation bias places greater value on this “evidence” that supports what they already believe and ignore anything that contradicts.

Recency Bias

A recency bias is very similar to confirmation bias but instead, it revolves around the recency instead of the confirmation of another source. Recency bias refers to recent events that confirm someone’s belief and this leads them to believe that this event is far more likely to happen again. Recency Bias is a very common pitfall in finance since people give more importance to short-term events compared to long-term events. The most popular example of this is when the financial crisis hit 2008 and 2009. Many investors were convinced that the stock market was going to suffer for quite a while due to “recent events”. However, if these investors were to just act rationally and logically backed with research and studies. They would have known that the economy will more than likely recover to its normal state or be better than ever.

Loss Aversion

Loss Aversion happens when investors are more concerned about avoiding losses rather than putting a higher priority on financial gains. This means they are far more likely to prioritize avoiding financial losses therefore not taking any risk to have financial gains. Investors with loss aversion might even avoid losses altogether even if the investment risk is acceptable.

Familiarity Bias

A familiarity bias is when investors only invest in what they are familiar with, comfortable with, or already know. As a result, investors are limited to their options meaning fewer opportunities for financial gains. Examples of these can include only investing in local or domestic companies or investments that they have a history with.

Final Thought

When you understand the different biases and tendencies we humans can have, you begin to understand and be more aware of its irrational impulses. When You become more aware, you also become more rational. A financial coach is invaluable when you need to make rational financial decision as the are emotionally attached. Lionhood Financial can help you make more of your money this way.

Learning is one thing, executing is a whole different story. After reading about biases and tendencies you might have; you can start making a mental checklist every time you make a financial decision. This mental checklist can be: Are my emotions affecting my decision? Am I jumping the bandwagon? Am I being overconfident? or do I have research to prove my point. After making a mental checklist you will be constantly checking up on yourself and as a result, it will lower the chances of making irrational decisions.