Psychology and our personal finances. Most of us know they’re linked in some manner, but don’t realize quite how much of a role our psyche plays in our saving and spending habits. I’ve always found it fascinating the role that psychology plays in the investment world. Our thoughts and emotions dictate everything from what assets we are willing to invest in, the timing as to when we enter and exit an investment, and even our appetite for risk. Yet even though this is becoming well known, I’ve still seen many older people who are willing to take on excessive risk in hopes of making a quick buck, only to lose a substantial amount of money and wish they went the conservative route. Likewise there are many millennials out there who have a very low risk tolerance and want nothing to do with stocks, even though they know that their investment horizon is long and that over long periods of time the markets have generated above average returns.
How can this happen when for some people it is so easy to follow the advice that professionals constantly are offering? One reason some people are too conservative is that negative events have a greater impact on us than positive ones. For instance, we feel more pain and regret in losing $50 than we do in winning $50, even though monetarily you’d think both events would have the same impact. This phenomenon is what’s known as the negativity bias. In the world of psychology this is where events of the negative nature have a more profound impact on an individual’s psychological state and processes than an equal, but positive event.
When I was a high-frequency options trader in Chicago I learned this the hard way. Losing trades made more of an impact on me than winning trades did. People have an obsession with being right, all of the time. Unfortunately, the world of trading is more of a game of probabilities and therefore you’ll always have a high number of losing trades in any given period. Even if you’re making money in the long run you’ll have periods of consecutive losing trades, and this can take a toll. The goal in this scenario is to not become emotionally attached to your investments and to understand when to cut your losses and trade another day. This example then begs the question, what can a person do to stabilize and improve their mental grasp of their finances? The answer is to reframe how you think about personal finances altogether. In this sense, to reframe something means to change how we think about it.
Below are five distinct ways in which a person can make subtle, yet profound, changes that impact their personal finances both in their day-to-day operations as well as with their long-term savings' plans.
Eliminate financial regrets from your portfolio of emotions
Bummed that you didn’t start saving for your future earlier than when you did? That makes two of us. In fact, according to a study at Northwestern University, one of the largest regrets that people have is finance related, with nearly 10% of people stating that it’s their biggest regret to date. Instead of focusing on the fact that you didn’t start saving sooner, however, praise yourself for starting when you did and achieving your progress up until this point. Another positive thing you can start doing, if you don’t already, is to track your net worth. When you track your net worth consistently it becomes visible just how far you’ve come as you can see the objective data to back it up. In a way it’s similar to hiking a mountain. If you only look at what lies ahead of you it seems as though you’re barely progressing in achieving your goals as the peak of the mountain still looks distant. If you take a moment to reflect on just how far you’ve come, however, it can be quite motivating and give you a push forward in times of need.
Differentiate your needs from your wants
In today’s day and age this is easier said than done. Everywhere we go there are things that catch our eye and make us want to spend impulsively. To effectively be in control of our spending, however, we need to determine what is a necessity versus what is a nice-to-have. Do you need a new car because your current one is finally at the end of its life and you need something reliable to get to work or do you want a new car because a newer model has just come out? Instead of convincing yourself that something is a necessity just so that you can validate your purchase it’s crucial to reframe how you view your needs versus your wants. Doing so will cut down your impulse spending, free yourself from revolving debt, and secure a better financial future moving forward. One method of doing this is to write down the reason(s) why you need whatever the high dollar item is that you’re going to purchase. Reread it later before making the purchase and see if it is still valid or not.
Disassociate your spending with your happiness
This goes hand-in-hand with differentiating your needs from your wants. People have been duped, one advertisement at a time, into believing that the more things they acquire the happier they will be. In most instances, however, the more possessions you acquire doesn’t correlate with how happy you are. Try to reframe how you view your possessions in a different light. Instead of focusing on what you don’t have, focus on what you do have and you’ll be much happier. In many scenarios the less you have the more likely you’ll deem certain possessions valuable. Every time we acquire a new “something” it devalues all of the other similar “somethings” that we own.
Understand that money is a tool
If a person’s goal in life is to make more money, odds are they will never be fully satisfied. Do you think that a person with $500,000 in savings will be much happier once they hit $600,000 in savings? What will most likely happen is that they’ll be happier for a very short period of time, then they will set their goal to reach $700,000. This will continue indefinitely, at some point they will just realize that they can never have enough. Instead of constantly trying to accumulate more money as a goal, try to think of money as a tool. A tool with which you can accomplish your true goals or passions (and no, buying more money isn’t an option). Sure, having more money will allow you to purchase more “things,” but as we just learned, purchasing more material goods rarely results in any increased happiness. Although having more money will make some tasks easier, such as starting a company or purchasing a house, if the goal is to simply get more money to buy stuff then we are going about everything in the wrong manner.
Detach your emotions from your investments
As mentioned in the introduction, psychology plays a large role in the buying/selling of your investments. Therefore it should be understood that a person’s emotions can dictate whether they make or lose thousands of dollars simply due to the timing of one’s investments or the decision to hold onto an investment because they don’t want to lose face and admit that they were wrong. One way to remove emotions from your investments is to write down the reasons why you got into an investment in the first place. If the reason was that the company had good fundamentals at the time of a purchase take another look at the fundamentals. If they still show that it’s a good investment then it makes sense to stay in, however, if the fundamentals have changed and they no longer represent a good opportunity then perhaps it’s time to sell. It’s also important to understand when an investment encompasses the sunk cost fallacy. This is when a person has already spent money on something and so they are tempted to stay in an investment because of this, even though it’s quite possible they’ll just lose more money going forward. Sometimes it makes sense to take a step back and see if it’s worthwhile to proceed or not.
It seems as though nearly every article written on America's spending and savings' habits is a negative one. Simple google searches will tell us how little the average American has saved for retirement or just how much credit card debt people are getting themselves into. It's easy to understand how so many people have dug themselves into a hole when it comes to their finances. People are infatuated with keeping up with the Joneses, living for today without regard for tomorrow, and for simply spending impulsively. By using the techniques listed above to reframe how we think about money, however, we can make a change for the better. So the next time you read an article on just how bad it is, try to focus on the positives from that article instead. For example, I recently wrote a blog post about how the average American has less than $100k saved for retirement. In it, however, I also detail how that's nearly a 4% increase since just the prior 3 months. By focusing on this fact, rather than the total balance numbers, you can begin to see the positives and develop momentum for moving forward.
Do you agree with the 5 ways listed on reframing how a person views their finances and investments?