Mindset, Biases, and Your Wallet
What were you thinking?
By now, it is likely you’re aware of the role your unconscious mind plays in determining your financial outcomes.
Whether it’s spending decisions or investment choices, the actions we take with our money are only partly driven by the numbers in front of us. Information only gets you so far.
You know the “correct” thing to do, but your mindset and biases often get in the way.
Broadly speaking, there are two avenues to journey.
Behavioral economics focuses very much on how humans often make not necessarily rational choices and exposes the common misperceptions of reality that we bring to the table as part of our human nature.
On the other hand, the field of financial therapy is more focused on you as an individual.
What were the formative experiences in your life that influence how you think about money today, and how do those thoughts translate into action (for better and for worse)?
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Common Money Biases & Mindsets
Let’s start macro: These are some of the most common biases that influence how we spend or save
Endowment Effect
A natural tendency to overvalue something simply because you own it.
For example, you want to sell your home and no one will pay the price that you have set. The market is telling you what the house is worth, but you don’t want to hear it.
Loss Aversion
A close cousin of the endowment effect is loss aversion. It’s quite natural to attach more value to what we have than to what we might have. (“A bird in the hand…” and all of that.)
This can play out in the investment arena, causing you to hold on to a losing asset when objective reality suggests it’s time to sell.
Researchers have also seen this play out in the way that some people approach their emergency fund, preferring to borrow money with interest rather than “raiding” their savings and seeing the balance drop. Even though that’s the intent of the fund.
Recency Bias and its sibling, Present Bias
Recency bias occurs when we weigh the probability of something happening in the future to be more likely, simply because it just happened in the immediate past. I see you, bull market investor.
Present bias leads us to go to lengths to avoid discomfort in the here and now.
What does this mean?
It’s far more painful to pay cash for a purchase today than it is to use your credit card and face the music later.
Even people who pay their credit cards off in full every month fall prey to this, spending more than they otherwise would have had they paid cash at the moment.
Mental Accounting
A dollar is a dollar, is a dollar…except in your mind. This bias can actually be quite helpful when we are trying to save for a large purchase.
For example, when you’re saving for a longer-term goal, segregating deposits into different bank accounts is a tried and true way to motivate you to reach that goal.
But this mental accounting can be destructive as well.
Many people will treat an unexpected bonus as money ripe for a major treat, despite having a more rational need for it (such as paying off a debt or adding to depleted savings).
We see a dollar earned as being somehow different than a dollar won and mentally account for it differently.
Fear of Commitment (or rather, Fear of Non-commitment)
One reason that researchers theorize some people are reluctant to use their emergency savings (see loss aversion) is that they’re afraid once they withdraw money from the account, they’ll lack the motivation to put it back.
On the other hand, a credit card company or bank will demand repayment.
We also see this effect when a household is unwilling to move funds from an account designated for their child’s future education, even at the expense of incurring debt today. (See mental accounting.)
It feels wrong to break that commitment to your child. Even if the economics of the decision are not in the best interest of your overall household economy.
As you can see, these biases work together forming a rather complex and layered symphony that’s human money behavior. And that’s before we account for our own individual idiosyncrasies.
Understanding yourself
In the field of financial therapy, much of the seminal work was done by the Klontzes, father and son. Their work emphasizes early life experiences and how that affects your money behavior today.
The Klontzes created the Klontz Money Script Inventory (KMSI).
Based on a series of questions, each person exhibits one or more “money scripts” that guide how they approach financial decisions in their life.
For example, a person whose dominant money script is “Money Avoidance” may feel that money truly is the root of all evil and avoid conversations about money. Or even take action to rid themselves of it.
In contrast, someone who’s Money Vigilant may exhibit a range of positive behaviors such as close monitoring of their spending. But you can easily imagine how that could go awry.
There are four money scripts in total.
No script is inherently bad or good; rather, the value is in understanding:
- how your mind works
- how it perceives money
- your ability to make choices with full knowledge of how your emotions may be affecting your decisions
So, what to do?
- Start by knowing thyself. Do you see yourself in any of the examples of biases above? Consider taking the KMSI assessment and discovering your dominant money scripts.
- Automate, automate, automate. If the trouble is that we tend to make suboptimal decisions, then make fewer decisions.
- For example, investment accounts that auto-rebalance (such as using a robo-advisor or simply a balanced index fund) keep you at your desired asset allocation, allowing you to escape recency bias that may prevent you from taking profits when the market is up.
- An automatic transfer directly from your paycheck to a savings or investment account allows you to avoid the feeling of loss that you would experience if you had to actively transfer money out of your checking account.
- Before each major money decision, ask yourself why you think its the right call. Is it based on analysis, or is there a bias at work here?
Having awareness of your money mindset and biases can help you better navigate your financial journey to avoid mishaps along the way.
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