Mind & Money: Looking at the Psychology behind Financial Decision Making

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  • Mind & Money: Looking at the Psychology behind Financial Decision Making

Consider this scenario: You walk into a store intending to buy only a few essentials, but you end up leaving with a handful of items you didn’t plan to purchase. Sound familiar? Welcome to the world of consumer psychology.

One of the most intriguing aspects of financial decision-making is the role of cognitive biases. These are mental shortcuts that our brains use to simplify decision-making processes. However, they can often lead us astray, especially when it comes to money matters.

There are a few factors that could come into play here;

  1. Anchoring: When making financial decisions, people often rely heavily on the first piece of information they encounter, known as the ‘anchor’. For instance, when negotiating a salary, your initial offer or the employer’s proposed figure can significantly influence the final outcome and subsequent decisions. This initial information often influences their judgments or estimates, even if it’s irrelevant or unreliable. Recognizing this bias can help individuals mitigate its effects by consciously seeking out additional information, challenging initial assumptions, and employing an analytical way of thought that encourage objective decision-making.
  2. The Endowment Effect: This describes the tendency of individuals to assign higher value to items they own compared to identical items they do not own. This effect has significant implications in various domains, including financial decision-making. The endowment effect is closely related to the status quo bias, which is the preference for maintaining the current state of affairs. Individuals may be reluctant to make changes to their investment portfolio or financial situation due to the comfort associated with their current holdings – emerging out of your comfort zone always seems tough. The endowment effect is crucial in financial decision-making as it can influence investment strategies, portfolio management, and even personal finance decisions.
  3. Emotional Impulses: During periods of market volatility, fear may prompt investors to sell their holdings hastily, potentially locking in losses. Conversely, eagerness for profits may lead investors to chase high-flying stocks without considering their underlying fundamentals. Speaking to and seeking advice from your financial adviser will help as they can provide objective guidance which can help counteract the influence of emotional impulses on financial decision-making.
  4. Social influences: Social influences come in many different forms. The ‘herd mentality’ phenomenon, where individuals mimic the actions of the crowd, can lead to irrational investment decisions. Think of the frenzy surrounding speculative assets like GameStop or cryptocurrencies, driven in part by social media hype and peer pressure. By recognizing the role of social factors in shaping financial behaviors, individuals can better navigate financial choices and make sure that they are making informed choices.

Fortunately, understanding these psychological biases can empower individuals to make more rational financial decisions. Recognizing the influence of anchoring, for instance, can prompt individuals to seek multiple sources of information before making certain decisions. Furthermore, cultivating financial mindfulness – being present and consciously spending – can help individuals resist impulsive spending and align their actions with their long-term financial goals. Also, it always helps to speak to your financial adviser about your current situation, any long term goals and life changes.

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