Most of us are familiar with the basic formula for financial success. Spend less than you make and invest the difference. On paper it sounds easy, but millions of people have trouble sticking to their budgets every month. It’s not a matter of a lack of math skills or an inability to use spreadsheets. It’s how we are wired in our brains to manage money that is the real problem.
The traditional economic theories presume that people make rational decisions and always act in their own best interest. Reality tells a very different story. We spend money on things we don’t need just to impress people who we dislike, and we sacrifice our long-term objectives for a short-term thrill. Behavioral finance can help. Understanding your spending psychology can help you make smarter decisions and stick to your budget.
Introduction to Behavioral Finance
The field of behavioral finance combines economics and psychology to explain the reasons why people make irrational decisions in their financial lives. In contrast to traditional finance, which assumes markets and people are rational and efficient, behavioral finance recognizes that humans are emotional. It examines the mental shortcuts, emotional triggers, and psychological factors that cause us to spend more than we can afford, save less, or panic-sell. It doesn’t take a PhD to understand this field, but you do need to be willing and open-minded enough about your own habits. Accepting that you aren’t a robot will allow you to create a budget that takes into account your humanity.
Understanding Cognitive Biases
Cognitive biases are systematic errors in thinking that affect the decisions and judgements people make. These shortcuts are used by our brains to process information faster but can lead us to make bad decisions when it comes to money. Confirmation bias, for example, could lead you to read only articles that support a purchase that you are considering and ignore advice that encourages you to save instead. The first step to correcting these mistakes is recognizing that your brain tends to make them. Awareness is the best way to avoid making impulsive decisions.
Emotional Budgeting: What role does it play?
Money is not just currency but is also deeply linked to our emotions. When work is stressful, we spend more to compensate; when we receive good news, we treat ourselves to lavish dinners, and when we want affection, we buy gifts. Your budget is more likely to fail if it does not take into account your emotional state. Your credit card is more concerned about your terrible day than a rigid spreadsheet. You need to know your emotional triggers to improve your budgeting. You can set up barriers to prevent you from shopping online before you feel sad.
Overcoming Bias in Current Spending
The present bias is a tendency to place more value on immediate rewards than long-term goals. The voice in your mind tells you that buying a phone today is more valuable than saving money for retirement thirty years from now. Saving money can feel like a punishment when the reward seems too distant to be real. You can combat the feeling by making the future more tangible. Set short-term goals that have immediate rewards, or visualize yourself in the future enjoying your savings.
Use Mental Accounting to Your Advantage
Mental accounting is the subjective evaluation of money by a person, which can have negative results. You might budget your salary carefully and treat it with respect. However, you may treat a tax return or a bonus at work as “free money,” which can be spent on vacation. A dollar is still a dollar, regardless of where it comes from. This concept can be used to your advantage when creating bank accounts that are dedicated to specific goals. You are less likely than usual to use your checking account for groceries when you label it “New Car Fund.”
How to Anchor Your Budget
When a person makes a decision, they tend to rely too much on the initial information provided (called an “anchor”). The anchor in retail is usually the original price of a tag. When a jacket’s price drops from $200 to $100, the brain tends to anchor to the original price of $200, perceiving the $100 price as a bargain, even if your intended budget was only $50. Budgeting is about establishing your anchors, based on what you earn and need, not external marketing. Before you consider the price, determine what you think an item is really worth.
The Power of Nudges in Financial Planning
In behavioral science, a nudge is an idea that uses indirect suggestions and positive reinforcement to influence the behavior and decisions of individuals or groups. Budgeting can be made easier with nudges. Automating your budget is the best nudge. Savings are taken out of your paycheck before they reach your account. You never get to spend them. Unsubscribing from retail newsletters will also remove the urge to spend. This makes it easier to stick to your budget without having to use willpower.
How to Create a Budget that is Brain-Friendly
It is not as simple as becoming an accountant to improve your budgeting abilities. Instead, it’s more about becoming a psychologist yourself. You can create a plan to work with your natural tendencies, such as biases and emotions. You can use mental accounting to safeguard your savings. Automate your good habits to overcome your present bias. And set your own pricing anchors. Financial stability is much easier to achieve when you stop fighting with your brain and begin to understand it.
FAQs
1. What is the most significant behavioral finance mistake you see?
Overconfidence bias is the most common mistake, when people believe they can control or predict events. This leads to poor investments and lack of emergency funds.
2. How can I reduce my impulse purchases?
Reduce impulse purchases by implementing “cooling off rules,” such as waiting for 24 hours before buying any item that is not essential and exceeds a certain threshold price.
3. Does behavioral finance apply only to investing?
Although behavioral finance is usually associated with investing, it can be applied to any aspect of money management, such as budgeting, debt repayment, and daily spending habits.
4. Why am I unable to save when I earn enough money?
This inability to save is often caused by lifestyle creep or Parkinson’s Law. Your expenses will rise in proportion to your income. Automating your savings is the best solution to this.
5. Can cognitive biases be completely eliminated?
Cognitive biases are a part of human evolution and cannot be eliminated. However, they can be reduced through awareness, systems such as automation, and reducing their negative impact.
