By Andrew Hatherley on Feb 27, 2019
If any good came out of the financial crisis and the Great Recession, it is that it made many of us become more financially literate and more aware of the need to pay attention to our finances. We now think before making purchases and we are better at prioritizing our expenditures. We certainly understand our credit situation much more clearly and many of us have worked out a plan to pay off our debt. And, we also are keenly aware of how important it is to save for the future. We now make lists, spreadsheet our budgets and even calculate our savings needs, all of which leads us to making better financial decisions.
But here’s the problem. When it comes to our actions, we rely 99% on our rational decision-making, and 1 percent on our emotions, and it’s that 1 percent that actually triggers the action. So, instead of following the rational line of thought that we so carefully forged in the left side of our brain, our actions are skewed by the fear, guilt, loneliness, exuberance or whatever emotion is swirling around in the right side. Because we can’t put emotions in a spreadsheet, we can’t account for them when its time to take action. And that is what usually gets us in financial trouble.
Here are a few of the financial dilemmas people still face today in which emotion tends to rule the day:
Paying Down Debt
Many people who are saddled with debt got that way with multiple credit card accounts. And, typically, at least one of those accounts is cranking out double digit interest charges. So, when the decision is made to follow a systematic plan to pay down debt, the rational approach would be to pay down the high interest debt first. The problem is that paying down high interest accounts, especially if they carry a sizable amount of debt, is a slow slog, and many people become discouraged when they don’t see enough progress in their plan. The innate need for instant gratification or positive reinforcement guides many people towards the smaller debts first, where they can more easily gauge their progress.
While there’s no really bad option when paying off debt, as long as it gets paid off, the small debt approach is likely to end up costing more in interest charges over time. We’re motivated by being able to check things off of their list, so we tend to tackle the small jobs first. If that’s what it takes to get through the whole list, then it’s not necessarily a bad thing. But, the costs will be higher. Logical? No, but we can easily rationalize our emotions to make it more palatable.
A lot of people have become serious about budgeting and prioritizing their spending. Unfortunately a lot of that happens on paper. When the tires hit the road for the mall or grocery store, we are always vulnerable to our emotions. Purchase decisions are, for the most, part based in emotion. How we are feeling at the time, or our general attitude, or our desire to keep up with Jones, can all come into play. Whether it’s buying the top sirloin instead of the ground chuck, buying house with more space than you need, or upgrading to leather car seats when cloth would do just fine; people tend to lead with their emotion and then rationalize their decision later.
It’s also emotions that lead us to using our credit cards instead of cash. While we know that using cash for our transactions helps restrict our spending, we can easily turn to a credit card to ease our guilt or escape reality when an urge to splurge comes over us.
This can be evidenced with the consumer borrowing data that shows how, after credit card debt and spending plunged in 2008 – 2009, it has suddenly spiked again, just as people are starting to feel better about their financial situations. And, for those whose situations have not markedly improved, buying things, can trigger good feelings, like endorphins. The fact that people are using their credit cards more, even though the average income hasn’t increased, is indicative of spending more than people can afford and adding to debt, which is not rational.
For those who are able to put money aside for retirement, investing can be an emotional roller coaster. Over the last three years, fear has driven most investors’ decisions, which is the primary reason why most people are not gaining any ground in their retirement accounts. It’s the fear of loss that drives investors to sell off their holdings, and it’s the fear of missing the boat that drives them back into the market. Unfortunately, most investors tend to sell only after the market is hitting bottom and they wait to buy when it is nearing or over its top. It is virtually impossible to generate positive returns that way.
The best course is to stay the course. The market will always drop, and, as it has done throughout history it will always climb more often than it drops. Investors, who stay focused on their objectives without worrying about chasing the performance of the market, will always do better by staying invested and making small adjustments rather than trying to time the market.
Overcoming Emotions in Finance
Unfortunately there is no easy solution that can take the emotion out of finance. Emotions are very powerful and very personal. The first step, however, may be the most important, and that is to become aware of your emotions when you are making financial decisions. That may enable you to break the rational-emotional decision making cycle. That means thinking all decisions through using your logic, and then as you are about to take action, asking yourself, “why am I doing this?” If you find yourself rationalizing action after you have already used your logic to make the initial decision, it means you are probably being influenced by your emotions. Stop, and take yourself back to your original rationale to determine if the action makes sense. It’s not easy, but practice makes perfect.
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