Are YOU Making Irrational Decisions About Your Financial Future? Research Says Yes.
When it comes to investing and other matters of personal finance, we like to think that we are objective and logical in our decisions. But according to an article in Yahoo Finance behavioral economic research says the opposite is true. Here are a few reasons cited to prove that most investors are mostly irrational about their choices and end up making bad decisions.
They are focused on not losing versus winning. Pro golfer Phil Michelson famously said he hates losing more than he likes winning. A similar mind set keeps us from admitting when we’ve made a bad investment and moving on because it’s more difficult to accept a mistake and see a loss. The result is that money becomes unproductive sitting in a place where it will not grow, and this impedes your financial progress.
They believe “The sun will come out tomorrow” myth. We are better at thinking about what we want to happen than actually taking steps to make it happen. One example is someone who hesitates to participate in his company’s 401(k) plan even though he knows he’s foregoing the company match incentive. He may think he’ll have more money in the future to put in or that he won’t really need the funds the 402(k) will provide because he’ll have made plenty for retirement. In the meantime, he’s losing out on not only ‘free’ money (that his company would put in), but he’s also losing out on valuable time to have that money grow.
They over-estimate their knowledge. We believe we are educating ourselves by watching TV or listening to the radio for advice. The financial news media is overcrowded with advice on “what stock to buy/sell now” and many people think they know all there is to know on the topic. However, TV and radio have but one goal, and it has nothing to do with helping you become a better investor. Jim Cramer and his brethren are all about one thing...ratings. Making financial decisions based on financial “televice” is irrational. They know nothing about you or your situation and just want to make sure they have enough viewers to keep paying the bills.
They justify sunk cost. This happens when you buy something that did not work out or you never used but you remain anchored to the idea of your original intentions. One study showed that well over 60% of people who buy fitness equipment or a gym membership either use it for a short period or not at all. However, they keep the equipment or membership because, in their mind, they still have the best intentions. Similarly, in investing, we don’t want to let go of a bad investment because we believe our original premise is going to work out eventually. So, instead of unloading it and taking a loss, we justify keeping it (and continue losing).
So what are some of the remedies for this behavior?
Now that we know WHY we make bad financial decisions, how can we start making better ones?
First, systematize the easy decisions.
In most cases you should not try picking individual stocks. If don’t have the time and resources to do extensive research and reading in addition to your normal profession, you should not try to be a stock picker. Instead, get help to find and use a well diversified mutual fund to start. Then set up an automatic investment into it using your checking account or a payroll deduction.
Many 401(k) plans have default enrollment options. You are automatically enrolled unless you choose not be. It’s an easy decision to NOT take yourself out of the automatic enrollment. Many plans also automatically increase your deferral amount, so as time goes on and your income increases, so does your contribution. An easy decision is to let this powerful took work FOR you instead of fighting it by taking yourself out of the plan.
Finally, work with a professional who can get to know you and your unique situation. Trust him or her enough to put the power in their hands, thus taking your personal (and often faulty) decision-making process out of the equation. There are many ways to get yourself on the right financial track and often the BEST way is to take your bias out of the decision-making process as much as possible.