Why are some people better savers than others?
More specifically, why are successful long-term investors able to delay gratification and invest well for their future, while others are not able to see past their short-term fears and desires?
A review of the concepts of behavioral finance will give us answers – and tips that everyone can use to make better and more rational financial decisions.
Since the interplay of biology and life experience influence financial perceptions and decision-making, a quick review of human brain structure is in order.
Humans have a triune brain, made up of three distinct sections.
The reptilian brain is responsible for instincts such as survival, hunger, fear and aggression. The mammalian brain controls more complex motivations, emotions and memory.
The third section of the brain, the cerebral cortex, is the rational, planning and decision-making brain. However, the cerebral cortex can be “hijacked” by the reptilian and mammalian brains, influencing our rational interpretation and decision-making.
IMPACT OF SCARCITY
Our brain and past experience determine our view of how much is “enough.” In turn, perceptions of abundance versus scarcity significantly affect our financial behavior.
In their book “Scarcity,” Sendhil Mullainathan and Eldar Shafir suggest that when people view something in their lives as scarce – be it money, food or time – they over-focus on it. In essence, the authors suggest in their book that the reptilian brain focuses on fear and overpowers the rational brain:
“By staying top of mind, [scarcity] affects what we notice, how we weigh our choices, how we deliberate and ultimately what we decide and how we behave. When we function under scarcity, we represent, manage and deal with problems differently.”
FIXATED ON THE PRESENT
Scarcity focuses our attention narrowly and causes us to lose sight of the broader picture.
During times of perceived financial scarcity, people fixate on near-term, looming bills rather than long-term goals such as creating an emergency fund and saving for retirement.
When the mortgage is overdue and money is tight, the annual furnace tuneup and roof inspection become low priorities, and just one problem can lead to a feast-and-famine spending cycle.
Other biases also can affect financial decision-making. Overconfidence can foster overly risky investment decisions, while irrational fears might cause one to attempt market timing – pulling out of an investment when there is an economic downturn, but then missing the opportunity to benefit from future gains.
To reduce the risk of getting in one’s own way when it comes to long-term investing, the best strategy for many may be to work with a trusted financial adviser.
The research of psychologists Fenja Ziegler and Richard Tunney suggests that when one is less emotionally involved in an outcome, more rational decisions are made.
A financial adviser who has emotional distance from a client’s life can help ensure that financial decisions are rational (considering long-term wants and needs as well as short-term, emotionally pressing desires and fears) and take into account long-term value as well as immediate costs.
Using these strategies will keep fear-driven or aggressive risk-taking behaviors from overcoming an investor’s rational brain, which will, in turn, make long-term financial goals easier to achieve.
Elissa Wurf, Certified Public Accountant, is a financial planning analyst at JoycePayne Partners of Bethlehem and Richmond, Va., responsible for developing and implementing financial plans for clients. She can be reached at firstname.lastname@example.org.