We all believe that we are rational people, especially when it comes to our money.
However, psychology suggests otherwise. It has shown that humans are imperfect information processors, and prey to all kinds of bias, error and perceptual distortion. Being human means our decision-making is anything but rational.
This is an interesting observation in the laboratory. But when it affects decisions about managing cash, savings and investments, it can become expensive in the real world.
At Continuum, we are looking at ways that psychology can put us wrong when we are preparing for the future and the strategies that might help put us back on the right track.
We want instant gratification
In today’s consumer-driven society, instant gratification is readily available. We get an instant reward when we spend in the form of something that we want. However, we don’t know what is around the corner. We do know we need to save for it.
Whether it’s buying a home, saving for a rainy day, or retiring comfortably, having clear objectives can motivate you to save consistently. Setting up automatic transfers to a savings account can help make saving painless.
It can also replace the instant reward we get from spending. Watching your savings rise with each monthly deposit and with every interest payment is a reward of its own which helps reinforce the saving habit.
We fear the unknown
Uncertainty breeds fear, and fear often drives us to make irrational financial decisions.
Dealing with these fears needs a well thought out financial plan.
The effective strategy is first to build an emergency fund. An instant access account gives you a financial reserve in place and eases anxiety about unexpected expenses.
Knowing that you have money set aside for emergencies can help you stay focused on your long-term financial goals – and reduce your fear of the future, making the present a great deal more comfortable.
Then look at the bigger picture. How can you make your spare cash grow, and build into a real cash lump sum? You may need to start thinking about investments. The investment world may contain some unknowns, but with help from a Continuum expert you can manage any fears that your risk-averse human mind may be harbouring.
We have cognitive biases
Cognitive biases are ways of thinking that cloud our judgment. Two common biases are loss aversion and confirmation bias.
Loss aversion is the tendency to avoiding losses even when it means avoiding gains. So people hold onto poor investments for too long, in the hope they will recover.
Confirmation bias is the tendency to seek out information that confirms our beliefs while ignoring contradictory evidence. This can lead to risky financial decisions based on overconfidence.
Seeking unbiased advice from an experienced financial adviser can help you make more suitable investment decisions.
Most panic – and follow the herd
We know logically that investment must be a long game, but when our portfolio values are plummeting, it’s hard to remember that over the longer term, equity markets tend to go up.
If we panic and sell up we crystallise the losses. The chances are that the market could make them back if we help our nerve.
We have a tendency to mimic the actions of a larger group, so the panic gets worse if we see other people jumping ship. This is because we don’t believe that the majority could be wrong. For the same reason, we can jump on investments that everyone else is buying. This is the root cause of the investment ‘bubbles’ that occur every few years.
Getting the help of an investment expert who can provide an objective point of view is essential.
But you are only human…
It is impossible to escape our emotions, biases and fears completely. However, financial security lies not just in the numbers but in the mindset and behaviours that drive your financial decisions.
At Continuum our experts combine a thorough understanding of the financial world with understanding of psychology. Time spent talking to them about your savings and investment plans can be the best investment of all.
To find out more, simply call us.
The information contained in this article is based on the opinion of Continuum and does not constitute financial advice or a recommendation to suitable investment strategy, you should seek independent financial advice before embarking on any course of action.
The value of investments can fall as well as rise and you may get back less than you invested. When investing, your capital is at risk.
The Financial Conduct Authority does not regulate deposit accounts.