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What causes people to make bad financial decisions?

Seven factors that affect our decision making.

Life is about choices, particularly financial ones. If we make bad financial decisions, our circumstances will likely be a reflection of these decisions. If we want better results, we need to make better, smarter money decisions. But, what causes us to make bad financial decisions in the first place?

Emotions

When it comes to money, greed and fear are the most often referenced emotions that are known to trigger bad decisions. As we know, when stock markets fall, investors panic and tend to sell shares to avoid losing more money in the short-term. Greed, on the other hand, can lead investors to turn to Ponzi and get-rich-quick schemes, fuelled by a desire to make as much money as possible in the shortest time.

While fear and greed can lead us in the wrong direction, they’re not the only emotions that our rational brains are susceptible to. Anger, such as that experienced in an acrimonious divorce, can lead embittered spouses to make disastrous financial decisions. Feelings of sadness and emptiness can lead people to indulge in ‘retail therapy’ in an attempt to fill an emotional void. In the race against the Joneses, jealousy and envy cause many people to live a more expensive lifestyle than what they can afford.

The link between depression and debt is well-documented, as debt can make one feel helpless, hopeless and low on self-esteem. Depression compromises a person’s ability to make clear and rational decisions, and in fact, can lead to lethargy and total inaction – which in itself can be a bad decision.

Emotions play a much bigger role than we tend to acknowledge – with many financial problems being mathematically simple to resolve but complicated by human emotions and feelings.

Financial fatigue

According to a recent World Bank study, poor people are more likely to make bad financial decisions because they are compromised by what is referred to as ‘financial fatigue’. Their constant, day-to-day financial struggles impact on their psychological resources and can result in bad decision-making. Being heavily indebted or being in dire financial straits can lead people to believe they will never emerge from their financial struggles and, as a result, more likely to continue making poor decisions.

By way of example, financial fatigue can lead a heavily indebted person to spend money buying lottery tickets instead of paying off debt. Tired of constantly worrying about money, running on the treadmill and living hand-to-mouth, those who suffer from financial fatigue are less resilient and more susceptible to bad money decisions.

Lack of self-control

When it comes to creating long-term wealth, self-control can be more important than intelligence. Being able to defer gratification involves extracting oneself from the current desire and focusing on some greater reward in the future. Exercising self-control involves planning and thinking ahead to what might be, and then weighing it against the opportunity that presents itself at the moment.

Being able to plan, think ahead, weigh up the opportunity costs and delay gratification is a key predictor of success later in life. Impulse buyers and compulsive spenders are unable to make the connection between how their expenditure at that moment is in effect a withdrawal against future financial security. Our culture of consumption has increased impulse spending as more and more consumers connect pleasure with purchase, despite knowing that the purchase if probably a bad financial decision.

Poor financial literacy

The failure to grasp and understand key financial concepts is another factor that can lead to bad decision-making. Essential money skills such as knowing how to draw up a budget and keep track of expenditure are important life skills that are very often not taught at home or school. Not understanding how compound interest can work either for or against you can lead people to buy on credit without a full appreciation for what they are paying in the long-term.

A lack of understanding when it comes to investment risks and rewards can result in people keeping their money in low-return investments that don’t keep pace with inflation over time. Not knowing one’s consumer protection rights can result in individuals not asking for refunds or replacements or being taken advantage of by big business. 

Biases

Behavioural and cognitive biases present real challenges to building wealth, and the truth is that we are all susceptible to them. Depending on our investor personality type, biases can affect the way we think or act which, in turn, can lead us to make poor decisions. Cognitive biases, such as confirmation bias, are emotional and affect the way we think or feel, whereas behavioural biases, such as herd instinct, affect the way we behave in certain circumstances.

For example, you may believe that cryptocurrency is the best place to put your money and then actively seek out information that supports your view. By succumbing to the confirmation bias, you deliberately filter out information that is contrary to your opinion and focus only on the information which reinforces your belief in cryptocurrency.

‘Herding’ is a common behavioural bias which results in investors following each other rather than undertaking their research and analysis. Using a ‘safety in numbers’ approach, investors herd together for fear of missing out on an investment opportunity. Relying on the false belief that ‘everyone can’t be wrong’, investors choose to follow the herd rather than get independent and well-researched advice.

Not getting advice

Not seeking sound, independent financial advice and attempting to go it alone can also result in poor financial decisions. Financial planning, which includes tax, retirement funding, estate planning, risk protection and investing, is a highly complex field to try and navigate alone. The belief that one knows more than an experienced, qualified advisor is known as an over-confidence bias. In many instances, it’s a case of ‘you don’t know what you don’t know’ simply because financial planning is not your area of expertise, although you like to think it is. Over-confidence is demonstrated daily by investors who attempt to time the markets, despite overwhelming evidence that it is rarely a successful strategy. Whether it’s through over-confidence or lack of trust, not having an advisor who can guide you can result in bad financial decisions being made.

Information overload

The sheer volume of information – and disinformation – makes it difficult to filter through the noise and make sound financial decisions. The number of investment types and options available to would-be investors is extensive, and information overload can lead to analysis-paralysis – being so swamped with information that you make no decision at all which can serve to compound your financial problems.

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