You know you need to spend less than you earn, budget, pay down your student loans, and save money for the future — but you still overspend and take on more debt.
So, why do you practice bad money habits even when you know better?
This is where the psychology of money comes in. Learning about your own financial psychology can help you develop better habits that will help you become successful.
Watch out for these bad money habits and take the first step to eliminating them — so you can save money and pay off your loans more quickly.
1. Temporal discounting
Why is saving and investing for the future so hard? The answer could lie in our language.
Economist Keith Chen suggested that people who speak languages, like English, are less likely to do things that benefit their future selves. This is because language like this distinguishes between past, present, and future tenses.
People who speak a language that does not have those tenses, however, are much better at taking action. These languages, like Chinese, are called “futureless languages.”
This means that English speakers are more prone to a cognitive bias called temporal discounting. This is the tendency to mentally place greater value on a reward that exists closer to us in time than rewards that are farther away.
So when faced with a choice to either save for retirement — that exists in the future — or spend money on a trip to the beach in three months, the beach trip seems more valuable. After all, it’s happening sooner.
To avoid falling into this trap, don’t give yourself the choice. Set up an automatic transfer from your checking account to your savings account each month. You can also ensure your student loan payments are automated, so you don’t miss a beat.
2. Recency bias
Recency bias is the mental habit that causes you to remember recent events more clearly than you remember past events. You then make decisions based on the most recent event — instead of looking at the bigger picture.
This can lead you to believe that things always will be the way they are now. Thinking this way can have a disastrous effect on your finances, though — just as it did during the mid-2000s housing bubble and subsequent crash.
Many people believed that because the housing market was hot at the time, it would inevitably continue to be hot in the future. This happens the other way around, too. Average investors tend to panic when the stock market starts crashing, and they sell their holdings.
If you’re not influenced by recency bias, you can think clearly and you know the stock market fluctuates. It’s much more logical to view a dip in the market as a discount on stocks that you can buy cheaper now and hold over time until they rise in value again.
Avoid recency bias by looking at bigger trends than just day to day — or even year to year. Plan for the long term and don’t base your money habits off a single event. This will allow you to overcome the psychology of money and have more money available to pay down your debt.
3. Loss aversion
It’s easy to feel more motivated to avoid loss than to achieve gain. That innate aversion to loss influences your financial psychology in several ways.
Think back to that stock market example. It’s so difficult to stay in the market when it’s tanking because you want to avoid loss. So even though it would have been better to hold course, your instinct is to sell.
Loss aversion can also keep you in bad financial situations. This is closely related to the sunk cost fallacy. This happens when you invest in something and continue putting money, time, and effort into that thing even after you realize it’s no longer a good idea.
Because you already feel so invested, you plow ahead anyway. But just because you already made it so far, doesn’t always mean you should keep going.
In this case, you need to cut off whatever you’re pouring into the situation. It’s painful and may feel illogical, but the real irrational choice is to continue on simply because you’ve already devoted time and money.
How to avoid bad money habits
The psychology of money is a complicated thing. The tendency to act emotionally and irrationally can create money habits that sabotage your success.
So what can you do about it?
- Automate when possible. Create a budget that alerts you when you’re close to overspending. Set up automatic transfers to savings, investment, and retirement accounts. Automating your finances can help reduce the conscious choices we need to make.
- Ask for help. It’s difficult to make logical financial decisions 100 percent of the time. An objective third party can help you make rational decisions when your biases and errors in logical thinking get in the way. You don’t necessarily need to pay a financial advisor either. You can check out Facebook groups, forums, and other resources that can give you objective, outside feedback.
- Challenge yourself. The best way to avoid any kind of bias around the psychology of money is to ask questions and challenge yourself. Examine the decisions you make and consider what motivates you. Ask yourself if you’re acting emotionally.
If you feel uncertain, don’t make decisions or take actions based on intuition, superstition, or emotions. Ask questions and learn more about your situation, your options, and what makes sense for your financial situation.
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