By Seth Edgil, Financial Advisor – Keystone Financial Group
Behavioral economics plays a significant role in how people manage their personal finances.
It combines elements of psychology and economics to explain why individuals make decisions that are not always rational, particularly when it comes to spending, saving, and investing.
The Influence of Emotions on Financial Decisions
One of the core concepts in behavioral economics is that emotions often drive financial decisions.
People aren’t always logical when it comes to money. According to Psychology Today, fear can lead us to avoid risk while greed can cause us to overlook risk.
For example, fear, optimism, or even guilt can lead individuals to make decisions that they later regret.
This becomes particularly apparent in times of market volatility, when people may react emotionally to short-term fluctuations instead of focusing on long-term financial goals.
Take the example of investing in the stock market. When prices fall, fear of losing money may lead someone to sell off their investments prematurely.
But research shows that markets tend to recover over time, and selling during a downturn could result in actual losses rather than potential ones.
On the flip side, when the market is booming, overconfidence might lead individuals to take on too much risk, potentially jeopardizing their financial security.
Loss Aversion: Why We Fear Losing Money
Loss aversion is a key concept in behavioral economics.
According to Investopedia, loss aversion is a behavioral phenomenon where a real or potential loss is perceived to be more damaging than the benefit received from an equivalent gain.
This suggests that people experience the pain of loss more intensely than the pleasure of a gain.
This phenomenon often causes individuals to make overly conservative financial decisions, such as keeping money in low-yield savings accounts instead of investing in opportunities that could offer higher returns over time.
While the desire to avoid loss is understandable, it can prevent people from growing their wealth and meeting long-term financial goals.
Short-Term Temptation vs. Long-Term Goals
Another common issue is the difficulty in balancing short-term desires with long-term financial objectives.
According to “The Behavioral Economics Guide 2017” by Alain Samson, hyperbolic discounting is our tendency to prioritize immediate reward over delayed reward, even if the delayed reward is better.
For example, buying a luxury item now might provide instant gratification, but it could compromise one’s ability to save for retirement.
To counteract this tendency, it’s essential to create systems that make saving easier. Automating savings and investments, for instance, removes the temptation to spend money impulsively.
This approach helps align everyday behaviors with long-term financial goals.
The Power of Habit and Small Wins
Building good financial habits can be challenging, but behavioral economics shows that small wins can lead to significant long-term progress.
The goal setting theory, originally proposed by psychologists Edwin Locke and Gary Latham, is a theory that explains how setting goals can influence behavior and improve long term performance.
Establishing consistent habits, such as setting aside a portion of each paycheck, can help people steadily improve their financial situation.
Even small savings contributions can accumulate over time, thanks to the power of compound interest.
Tracking progress is also a powerful motivator. Seeing tangible results from saving or paying off debt can encourage individuals to stay the course and continue working toward their financial objectives.
Improving Financial Decision-Making
The principles of behavioral economics offer valuable insights into how we can improve our financial decision-making.
By recognizing the emotional and psychological factors at play, individuals can make more informed choices that align with their long-term goals.
Structuring financial plans to minimize emotional reactions and establishing healthy habits can lead to greater financial stability and success.
