Personal Finance Apprentice

7 Behaviors That Silently Affect The Way We Handle Money

7 Behaviors That Silently Affect The Way We Handle Money. Our mind is a funny thing sometimes. The same reality, if perceived differently can result in different decisions or outcomes. In this post we'll look at how behavioral economics affects our decisions in ways that we ourselves are sometimes not aware of.

7 Behaviors That Silently Affect The Way We Handle Money

Our mind is a funny thing sometimes. The same reality, if perceived differently can result in different decisions or outcomes. What do I mean?

Take for example the money in your wallet. As you’ve probably heard, if you want to save money or just spend less, have bigger denominations in your wallet.

Now there’s no reason that should be effective. After all, Php1000 is Php1000, whether it’s one Php1000 bill, 2 Php500 bills, or 50 Php20 bills. But in reality it’s easier for us to spend those small bills than see a Php1000 get broken down.

It’s called the Denomination Effect.

And it’s not the only “irrational” behavior we have when it comes to money.

For example, if you’ve ever tried or thought of selling an item you own, chances are your initial selling price would be higher than what most people wold be willing to pay for it. And even if your selling price wasn’t much higher, most likely you
felt that the price you placed on the item was really cheap – even if it
was comparable to similar items on the market.

There are several possible reasons for the discrepancy like sentimental value or knowledge of how good its condition is.

But in truth, studies have shown that it’s because we generally place higher value on things we own. It’s called the Endowment Effect.

A possible reason for this Endowment Effect is that people generally prefer avoiding losses than acquiring gains – the Loss Aversion Theory. Essentially we are so averse to loss that it takes a much higher gain to convince us to part with an item we own.

This theory could also help explain the sunk cost fallacy. We may be
reluctant to “let go” of the results of past efforts or expenses
possibly because we view it as a loss.

An example of the Loss Aversion Theory is a person investing in the stock market, who considers himself a trader rather than a long-term investor, but refuses to cut loss and instead waits patiently to break even and then immediately sells (perhaps in fear that another correction is near after this most recent rally).

Objectively speaking, there are better options than waiting for a 0% gain. However, for pretty much everyone, we have to push ourselves get over the hurdle of accepting a loss when we reach a stop-loss point.

And that is actually related to another counter-intuitive investing approach called the Disposition Effect. This effect is the tendency to hold on to losing stocks (gaining no money, but avoiding loss) and selling shares that have appreciated in value (which potentially limits gains).

If anything, we should hold on to stocks as long as they keep gaining, and immediately sell losing stocks and re-allocate the freed up funds to better performing assets – whether stocks, cash, bonds or other investments.

And since we’re on the subject of stocks, how often do you hear that the stock market is “due” for a correction or a rally? It’s common to hear such talk after several days of consistently bad or good market performance.

And if we’re honest with ourselves, we probably accepted such declarations as intuitive – it just sounds right, if we think about it. But in reality it’s far from certain. This is actually called Gambler’s Fallacy.

Seven straight “red” trading days doesn’t mean it’s about to go “green” anytime now. It can keep going down. Or worse, it can rise slightly and then promptly nosedive to 52-week or even all-time lows.

But of course, this fallacy is hardly a big hurdle when it comes to investments. Who really buys and sells depending on recommendations they read in the news? Most likely no one.

However, it’s not uncommon to see groups gather together and form similar opinions on one or more topics. For investors, it’s also pretty unremarkable. At least up until the point where these large groups of people start acting in a similar fashion – either by succumbing to fear or greed and frenziedly buying or selling shares. This is called Herd Behavior, and is usually seen at the start or end of long-term market trends.

Simply put, if you’re part of the herd you aren’t going to make money.

Of course, going solo is hardly without pitfalls. For one, people have a tendency to be indecisive and instead opt for the status quo. This is called, unsurprisingly, the Status Quo Bias. This is once again related to our aversion to loss; essentially, in our mind, the threat of possible losses outweighs the promise of potential gains.

It’s not a bias if the status quo is the best option. Instead this refers to preferring not to make any changes for fear that we may regret that change. Essentially, we’re not sure of the other option’s outcome, so we just maintain the status quo.

An example of Status Quo Bias – though not related to stocks anymore – is sticking with our bank, cable company, isp, or phone service provider. At first it seems logical; there was a reason we chose them in the first place.

But after some time (and not even a long time) that would be true only for some of those items. If we look hard enough, we’ll most likely find a better alternative. So in effect, we stick with it simply because it’s the default option.

Of course, none of these mean we’ve been making the wrong decision all these years. They’re just predispositions and tendencies. But it does help to know they exist.

Good financial decisions are mostly rational and based on logical reasons. Sometimes it’s unavoidable to make decisions based on sentiment (and sometimes that’s actually the correct way). But it doesn’t hurt to be able to set aside some of those emotions and clearly think things through a couple of times.

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photo credit: Trishhhh via photopin cc
photo credit: benleto via photopin cc

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