How the appliance of science can help us make better financial decisions
Although we like to think that we are rational, making financial decisions based only on logic, we all have unconscious behavioural tendencies which have the potential to throw us off course.
This can help explain why, at times, we struggle with our finances; whether it’s making investment decisions or simply starting to save in the first place.
Behavioural finance is a field of study dedicated to understanding more about this; exploring the psychological factors that can influence us when making financial decisions and how our unconscious mind can influence these decisions (without us knowing it), often to our detriment.
One of the biggest factors in our decision making is ‘present bias’, which sees us place a greater priority on what we want or need today rather than in the future. So, although spending money on a summer holiday may seem to be a wholly justifiable expense, it can cause us to divert money that could be better used elsewhere, for example invested in our pension plan.
‘Status quo bias’ keeps us from changing our normal patterns of behaviour, even when we know it’s the right thing to do (such as saving for a rainy day or retirement). Over-optimism is also a common trait where we believe ourselves to be ‘lucky' and that misfortune will only happen to others.
How experts use the science
One way experts are using behavioural theory is to encourage successful retirement planning. For example, the government is battling ‘present bias’ by using auto-enrolment for workplace pension schemes.
Without this, many people would delay saving into a pension, choosing instead to spend it in the here and now, thereby missing out on the magic of compound interest.
However, researchers have found that if an employer removes the need for us to opt in and instead auto-enrols us into a pension scheme and allocates a respectable percentage of our before-tax income into it, we’re usually happy with the outcome. If not, we have to decide to opt out. However, studies have shown that this rarely happens.
How we can use the science
While providers of retirement plans consider how to incorporate the findings of behavioural finance research into their products and services, we can also make use of this science:
To overcome ‘present bias’ we could try our own, adapted form of auto-enrolment. For example, rather than trying to remember to make contributions to our savings each month, we could try setting up a standing order to make automatic contributions.
To overcome ‘status quo bias’ we could enlist the help of friends to encourage us to make positive behavioural changes, such as saving money or investing into a pension. This is why many weight-loss programs use group weigh-ins to motivate people to stay focused on their goals.
If you have already started saving or investing, be aware of the ‘endowment effect’, which makes us overvalue what we already own. This could result in sticking with something unprofitable due to an aversion to loss and trying to avoid a loss all costs.
Whilst the above provides an insight into some aspects of behavioural finance theory, it is important to remember that we are all different and will therefore all have different behavioural biases.