Think of what you would do if you got an unanticipated bonus at work worth 25% of your base salary. Would you use it to pay off an existing loan or invest it for a long-term goal, like buying a home? Or would you book a fun vacation to Italy’s Amalfi Coast and go on a shopping spree? Would you wait until you’ve had the time to think about what to do with the money and discuss the matter with your spouse, or would you spend it immediately? Would it even make you very happy, or would you feel like 25% is not enough for the work you do?
To a large extent, the answer to all these questions depends on your psychology — your money habits, attitudes, beliefs, and behaviours. While traditional economics often relies on idealised models, the real world is much messier, and people are prone to being influenced by various irrational factors in money matters as well. Understanding how this impacts your behaviour is crucial to your financial well-being.
What is the psychology of money?
A lot of early economics theories and “laws” were based on the rational choice theory, which holds that humans make rational calculations and choices that maximise their self-interest. But over time, the field of behavioural economics has recognised that individuals will not always behave in predictably rational ways. That’s because people and their financial decisions are deeply influenced by their emotions, cognitive biases, personal experiences, and social context.
If you understand how these psychological factors impact your relationship with money, you can identify emotional triggers and thought processes that impact your spending habits, saving and investment patterns, and overall financial health. This can allow you to make more rational and informed decisions, and develop strategies that can help you meet your financial goals effectively.
Understanding your money habits and behaviours
Here are some common psychological factors and biases that tend to impact your money decisions:
- Emotional triggers
Emotions play a significant role in your financial decisions. And it’s important to understand what your emotional triggers are so that you can regulate them and make more prudent financial decisions. For instance, many individuals link their self-worth to the things they own and tend to buy goods of conspicuous consumption — purchasing lavish goods that act as a status symbol and add to one’s prestige. Such a person might even keep buying the latest gadgets or constantly upgrade their car, even if their income doesn’t really allow for it.
Emotions and social context also influence your investment decisions. As you know, your risk tolerance plays a crucial role in the way you invest and the securities you invest in. And rationally, an individual’s risk tolerance is determined by their age, income, existing debt, and financial obligations. So, ideally, somebody who is 28, has no debt and has several income-earning years ahead of them should have a high-risk tolerance. However, if their personality is highly cautious and they tend to get anxious easily, their risk tolerance when it comes to investing may be moderate to low.
- Present bias
This cognitive bias refers to the tendency during decision-making to prioritise immediate gratification and rewards over future benefits. If this bias is at play, then an individual will tend to indulge in impulsive spending and fail to adequately plan financially for a secure future. For instance, not having retirement savings in place and prioritising travelling “because YOLO”. Or indulging in heavy discretionary spending regularly, like buying designer clothes, and bags instead of paying off existing credit card bills, not realising that this will negatively impact their credit score and ability to seek financing when required.
This can lead to financial stress and instability down the line since a big part of personal finance is financial planning — building an emergency fund for financial contingencies, investing for long-term goals, building a retirement corpus, and more. It’s important to remember that most times, when it comes to financial decisions, your needs must be prioritised over your wants.
- Sunk-cost fallacy
The sunk-cost fallacy rears its head when you keep doing something despite not getting the desired outcome just because you don’t want to abandon something you have already invested a certain amount of money, time, and energy in. This is a particularly dangerous cognitive bias to fall for, because it will make you throw good money after bad.
A common example of the sunk-cost fallacy in investing is when an investor keeps holding on to an investment like a stock or mutual fund that has been consistently underperforming because they don’t want to book capital losses. However, knowing the right time to exit and to cut your losses is essential.
- Anchoring bias
When you rely too heavily on an initial piece of information when making a decision, that’s the anchoring bias at play. The most common example of this is during salary negotiations. If in an interview, the interviewer asks you what your salary expectation is, and you end up proposing a low amount, the interviewer will often anchor their counteroffer to that low amount even if the budget for that role is higher and you have all the necessary qualifications.
The anchoring bias also comes into play if you tend to rely too much on the opinions of analysts or fellow investors. If investors around you are bullish on a particular stock or sector, then that can create an anchor for you and your expectations about the stock’s performance and decisions relating to it over time may not be based on market trends and your own analysis, but the initial opinions you heard. Another way the anchoring bias plays a role during investment decisions is if you focus too much on historical prices of investments. Hence, the popular investment disclaimer — past performance does not guarantee future results.
How to transform this self-awareness into action?
Understanding the psychology of money and the biases that impact your financial decisions is crucial. But such biases are not something you can eradicate in one go; instead, recognising and taming them requires patience and humility. One thing that definitely makes this process easier is having the right kind of support.
Appreciate is an investment platform that empowers you with insightful tools to make informed decisions and provides tailored solutions, allowing you to take control of your financial future. Appreciate’s AI recommendations can help you reduce the impact of your biases on your investments. In addition, with Appreciate, you can set financial goals, start systematic investment plans in securities to invest regularly and develop financial discipline, and enhance your financial knowledge.
Download the Appreciate App and embark on a journey towards financial well-being today!
