Coming into the holiday season (which often involves lots of extra spending) I thought I’d do a couple of blogs on money. One particularly useful concept to reflect on at this 'high spend' time of year is behavioural finance.
Once I started working in superannuation, I became fascinated with behavioural finance – the mix of psychology and finance. I’ve sat through hundreds of investment meetings and was surprised that seasoned professionals would get nervous about markets, even though they allegedly knew about expected volatility.
In 2002, I was able to use an award I won to learn more in this field from some of the best in the USA. In fact in 2002, a psychologist Daniel Kahnemann, won the Nobel prize in Economics for his findings in this space! And only weeks ago, the 2017 Economics Nobel prize went to Richard Thaler who has furthered behavioural finance applications. So what are some important insights from this growing field?
• Money decisions aren’t that rational. In fact, whilst we’re bombarded with fine print, it doesn’t always help. I once said to a group of regulators that they should hire some journalists as well as lawyers to communicate with ordinary consumers!
• Losses are feared far more than gains are desired (Daniel Kahnemann’s work). This is why people put another coin in a poker machine when they’re losing. It’s the phrase – “good money after bad”. Kahnemann found that losses are feared about twice as much as gains are desired. It’s not until markets are falling that you really know how you are going to react, especially when you’re retired and are living off the earnings on your money.
• Richard Thaler discovered that money is treated differently depending on its source and size, even though it all spends the same. People might worry about cents when it’s about the price of petrol, but don’t negotiate every cent when buying a larger item. Wouldn’t it drive everyone crazy to haggle like that on a house purchase? “I’ll offer $525,089.63 – no take it up to 70 cents!”
• People can be overconfident about their ability. You might think you’re the above average driver on those days when it seems like you encounter many idiots on the road. So too it is with money. Confirmation bias tells us that when we win (perhaps markets are going well), we’ve made a great decision. But when we lose, someone else is often to blame.
Now you probably recognise yourself in some of the above. I know I still laugh at myself after tripping up on a bias. So with behavioural finance principles in mind, what practical advice do I give people about managing their money?
• Have a plan – yes that is, have a budget. Think about your money as if you were a business. Now some like to plan for every little item, whilst others like to put aside enough for big ticket expenses and then have flexibility with the remaining money. I always suggest converting spending and pay rises to annual amounts. Don’t fall into treating money differently depending on its relative size. For example, don’t think, 'well I’m already spending $200 on a present for my beloved, so another $20 is not much more.' Also, a pay rise of $10 a week might seem paltry, but that can be $520 for next year’s Christmas presents.
• Set up some sensible defaults to get you on the right track. Richard Thaler designed a system called “SMART” – Save More Tomorrow where people commit to save some of their future pay rises. It’s a neat idea that progressively adds to your savings.
• If you come into some money, the academics recommend that you should park it for a while – because then you treat it more carefully as it changes form in your brain from being “found” money to “saved” money.
I’ll write a little more next time, but as I’ve said before, the greatest resources you have are time, money and health. Money gives you wonderful options in life so focus on it and use it to design the life you want.
Until next time.