Why People Make Bad Financial Decisions And How To Avoid Them
Have you ever wondered how we humans make decisions? Especially those bad financial decisions that you end up regretting for a long time afterwards. Often we don’t think about these decision long enough to realise they are not the best course of action. But why is that?
How do we make decisions?
There are two terms used in psychology called heuristics and cognitive bias, and they are closely related.
Heuristics are mental short cuts to help our brains manage the amount of daily tasks and decisions we face. Some of them are useful and preserve our energy. Some on the other hand can lead us to biased behaviour.
Biased behaviour is behaviour which differs from the standard, it can be illogical and lead to less than ideal decisions. This might be because you are missing, or ignoring, relevant information needed to make a logical decision.
Why do heuristics and biases often lead to bad financial decisions?
Managing your finances is full of making decisions. Furthermore, financial decisions can be quite emotional and require financial literacy to understand the decision, and the consequences of it.
This can mean that financial decision are often made with the help of heuristics which can lead to biased behaviour, and therefore to decisions that are not optimal.
Behavioral finance is an area of study which aims to understand this phenomenon.
It is important for financial advisers to understand how people think and why someone might be reluctant to do something that is beneficial to them, or why someone might have their mind set on doing something that is illogical.
Understanding where these thought patterns might originate from can help advisers to help people they advise to see past it. And the way you can help yourself, is to be aware of them.
Before you make any important decisions, stop and think.
Have you considered all the relevant information objectively?
Are you aware why you are making this decision?
If you are not 100% sure why you want to buy an investment, or make other money related decisions, maybe look into your options and possible consequences a bit deeper. Or reflect on your own why.
You can read more about heuristics here.
In this blog I will go through different types of heuristics and biased behaviours so you can be better aware of them while you make the best financial decisions for you! You can find the first post here.
Had you heard of heuristics before? Is there any specific ones that come to your mind? Leave a comment and let me know!
