People are prone to letting biases and emotions influence their decision-making abilities, and this behaviour extends to making financial choices too.
These biases and emotions come in the way of making rational and practical decisions in money matters. Emotions, cognitive biases, and heuristics form a set of psychological factors that impact our decision-making process, further studied and analysed in a field called behavioural finance.
You can only analyse your own behaviour, make better financial decisions, and pay off debt if you have a thorough understanding of behavioural finance and how different factors affect you.
This becomes especially important when you’re dealing with a constant cycle of debt that prevents you from achieving your long-term goals. While fair lenders like Salad Money ensure that you only borrow what you can repay, many other lenders may leverage behavioural finance to keep you stuck in a debt cycle.
However, by understanding behavioural finance, you can effectively avoid falling trap to a cycle of debt and manage your finances better.
So let’s get started
Understanding Behavioural Finance
Behavioural finance is a part of behavioural economics that studies the impact of psychological factors and emotional influences on our financial decisions and behaviours.
Conventional financial wisdom assumes that people think and make decisions based on rationale and after accounting for all available information. However, certain behavioural finance principles argue that people often end up making decisions influenced by biases and emotions that can be far from rational.
Understanding behavioural finance is the first step to comprehending and acknowledging how emotions often cloud judgment and push us to make choices that don’t align with our long-term goals. For example, panic selling of stocks during market downturns or chasing risky assets during booms.
As more research has gone into this intriguing field, researchers are unlocking insights into why people behave the way they do when it comes to making decisions in finance.
How Emotions and Biases Influence Our Decisions
Of the multiple biases and emotions that dominate our financial decision-making process, let’s explore the four most common ones.
1. Confirmation Bias
Confirmation bias is a common type of bias where you tend to seek information that confirms your pre-existing beliefs and ignore the information that contradicts those beliefs. It can lead you to have a false sense of belief about your financial decision, even if the information is flawed. By recognising this bias, you can embrace an all-encompassing approach when seeking information and making more informed decisions.
2. Overconfidence Bias
Overconfidence bias is when people believe they have more control over the outcomes of their investments than they actually do. People who engage in this behaviour may irrationally make high-risk investments and incur debt. It’s only when you acknowledge this bias that you can avoid risk and make more rational investment choices.
3. Experiential Bias
Experience bias, also referred to as availability bias or recency bias, occurs when a person’s recent recollection of an event affects how they make decisions. An example of past experience influencing present decisions was the global economic downturn of 2008–2009, which led many investors to steer clear of the stock market in fear of potential losses. Even after the economy recovered, many investors hesitated to invest.
4. Risk Tolerance
Take a more objective approach to risk by understanding your risk appetite and how your emotions affect your risk perception. The uncalculated risk may lead to detrimental outcomes, such as pushing you into a debt spiral. Being too cautious about your investments means missing out on opportunities to approach your financial goals.
4 Ways to Use Behavioural Finance to Overcome Debt
Let’s now explore 4 ways to identify biases and emotions that come in the way of your financial judgment. Working on these psychological barriers can help you overcome debt.
1. Identify Biases
Reflect on your past financial choices and recognise any biases that may have influenced your decisions. For instance, underestimating the risks of investing money may stem from an overconfidence bias. A debt situation may have arisen from miscalculating or underestimating financial risks. Only when you identify and acknowledge these biases can you take steps to overcome them and make better decisions in the future.
2. Set Realistic Financial Objectives
Setting realistic and grounded financial goals helps you make money-related decisions that align with your needs. For instance, if you plan to buy a home in the future, you may need to start saving up in a savings account. This goal can keep your finances aligned and prevent you from overspending. In this way, you design a roadmap for your financial journey and stick to making more financially sound decisions along the way.
3. Systematic Investments
Short-term market fluctuations may seem tempting to invest in for a quick profit; however, it’s best to avoid being swayed by emotions to invest on impulse that may propel you towards debt. Instead, embrace a systematic approach towards investing money for better investment outcomes where you invest regularly and consistently over a period of time.
4. Seek Professional Help
Don’t be afraid to seek help from finance professionals to navigate you out of debt. Financial advisors can guide you out of debt with their expertise and guidance and also support you in making informed decisions in sync with your financial goals.
To Sum Up
Understanding behavioural finance and its impact on the financial decision-making process is a valuable exercise. Take advantage of the behavioural finance principles and employ them in your decision-making process to overcome debt, tailor better financial outcomes, and improve your overall economic well-being.
The key to a successful financial future is to stay disciplined, consistent, patient, and committed to your short-term and long-term goals.
