Because we suck at it.
To be honest, your brain isn’t that great at a lot of things. Don’t take that as an insult— I’m sure you’re an extremely smart individual (I mean you are reading my blog post, after all).
I’m saying that you — just like all other humans — are irrational.
I’ll prove it to you. Just take a look at this picture:
At first glance, these lines look crooked. But go ahead and slide a ruler along each line, and you’ll see that they’re perfectly parallel.
This is an example of your brain playing tricks on your, in the form of an illusion. It turns our minds are constantly playing tricks on us — making decisions on our behalf before we have all the facts. We often supplement factual decisions for ones based on emotions, biases and “heuristics” (rules of thumb).
I’ve been really interested lately in how our irrational tendencies affect money habits. So I’ve done some digging into the concepts of behavioral finance and neuroeconomics — the study of how our brains react to economic situations. Here’s what I found…
Your Brain Sucks at Budgeting
#1 — Habit Creation
Creating new habits is hard. But there’s reason to believe that it doesn’t have to be as hard as we make it for ourselves. If you’re like most people, you’ve got a New Year’s resolution in place and may even still be sticking to it. But realistically, you’re probably going to fall off eventually. (Sorry!)
Take it from Nir Eyal, author of Hooked: How to Build Habit-Forming Products:
We make well-intentioned goals, with the false belief that we just lack commitment and motivation; that all we need is a good kick in the ass to get us going. This couldn’t be farther from the truth.
We often blame our failures on a lack of motivation. We think we weren’t able to stick to a budget consistently because we simply didn’t push hard enough.
Nir argues that this isn’t the root of the problem. The real issue lies with how we try and build habits. Instead of implementing daily routines and system, we set goals and look for one-off solutions using things like…
#2— Social Proof
Yup … peer pressure. It’ll get ya.
People often base their decisions on what their friends and colleagues do. This is more prevalent for tougher decisions…like budgeting. Very few people want to budget. It’s time-consuming and tedious work. So they turn to what they think will be the easiest solution.
The envelope budgeting system, for instance, is widely endorsed by many personal finance gurus as the “right” way to budget. This system may not be right for everyone. But it’s easier to choose a solution that’s widely used rather than find the best solution for yourself.
Your Brain Sucks at Paying Off Debt
#3 — Mental Accounting
Why would the envelope budgeting system not be right for everyone, you ask? Because it can cause the bad habit of mental accounting.
By mentally dividing your money, you’re setting aside a bit of money each month for clothes, a vacation, retirement etc. and also paying off your debt. While you’re freely spending your clothing allowance, you are accruing interest on your debt. Rationally, the benefits of paying down debt greatly outweigh the advantages of mental accounting money into categories where it is “supposed” to be spent. You don’t want to get into a habit of “this money needs to be spent on entertainment”.
Your Brain Sucks at Spending
Do you have at least one credit card in your wallet? Probably.
But studies have shown that people don’t treat cash and credit cards the same. People are way more likely to spend money or make big purchases when shopping with a credit card. George Loewenstein, a neuro-economist at Carnegie Mellon University, says:
Unlike cash, where you are turning something over (bills and coins) as you are receiving something (a good or service), with credit cards you or the store clerk simply swipes the card, which doesn’t feel like giving something up.
Your Brain Sucks at Investing
#4 — Availability Bias
Unfortunately, those who invest in the stock market often use mental shortcuts to make their research easier. Availability bias is sort of your brain’s way of justifying laziness. It’s when your brain weighs the information you already have handy more heavily.
If you’ve got a friend who made $10,000 in the stock market, you’ll weigh that info heavier than the complex economic conditions of today, even though they may not be the same as they were when your friend invested. This can threaten your portfolio.
#5 — The Endowment Effect
We demand a higher price for something than we are willing to pay someone else for that same thing. If I own a share, I will value it at $100, but would only be willing to buy that same share that someone else owns at $95. This can lead to the all too common problem of buying high and selling low.
#6 — Mean Regression
Mean Regression is the theory that all stocks have an “average price”. The belief is that daily fluctuations in stock prices are temporary, and the price will ultimately return to the average. However, these movements could be caused by other factors like internal problems or macroeconomic effects.
Anything I Missed?
These are just a few of the ways the mind plays tricks on us. Are there any other psychological factors that effect the way you spend, save and invest your money? Let me know with a word below!