Yahoo Finance UK The hidden reasons we don’t do the right thing with our finances Read full article Sarah Coles · Personal Finance Columnist 16 November 2023 at 11:59 am · 6-min read Just because you spent £300 per person on Christmas presents in the past, doesn’t mean your finances will bear it every year.Photo: Getty (Betsie Van Der Meer via Getty Images)
Most people assume that managing our money means getting our heads around the maths involved, but it’s less clear cut and scientific than that.We also get sidetracked by emotions and scuppered by faulty assumptions.So if we really want to get to grips with our finances, we need to understand what’s leading us astray so we can nip it in the bud.
Emotions play more of a part in our finances than we may realise.
It’s why there’s a good chance at some point you may have bought something to cheer yourself up, or to reward yourself for getting through something hard, or because you were bored in an airport, or because you felt bad for someone and got them a present.It’s why it’s always a good idea to take a breath before reaching for your wallet, to think: why am I buying this? Do I really need it? Some people make a rule to leave things in virtual shopping baskets for a fixed period before buying – to make sure they really want it.
But quite aside from our emotions, there’s an awful lot going on in our subconscious too.In every moment of every day, we’re making a bunch of tiny and unimportant decisions, like whether to have something to eat.
We don’t always have the time and energy to make these decisions consciously, so we use mental shortcuts or rules of thumb, so if we usually have breakfast at 7, we’ll have breakfast at 7.
It’s the only way to avoid thinking ourselves to a standstill.However, if these rules of thumb are faulty, we can end up making the same mistakes over and over again, and there are some common ones that can catch us out.
Anchoring is where we rely on the first piece of information we get about something.So we may decide, for example, that all the Christmas presents we need to buy cost £300 – because that’s what they cost a few years ago.It means we save £300, and go shopping.However, with inflation running so hot, this year those presents might cost £350, so we’re going to end up overspending or running out of money.
Story continues It can also get us into trouble when it comes to selling assets – like shares or our home.We think of what we paid for it as the fair price, when in reality this will rise and fall with the market.It’s why we can end up hanging onto underperforming investments – thinking they must recover to their fair price, or we overprice our property and are surprised that we can’t sell.It’s why when we’re estimating costs or the value of anything we need to be aware of this bias at play.
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We also need to steer clear of mental accounting.
This is where we mentally split out money into different pots for different things – so a credit card bill might come in at £300 and we have £300 in a savings account, but because we think of our savings as being for a holiday, we don’t use our savings paying our debts.We pay far more in interest than we make on the savings, and we’re fooling ourselves, because if we’re running up debts, then we’re not really saving, we’re just allocating our money badly.
Just because you, or.your friend, or your friend’s friend made some money on Crypto once, doesn’t mean you will be able to do it again.Photo: Getty (seksan Mongkhonkhamsao via Getty Images) One of the better-known behavioural mistakes is herd mentality.This is where we end up doing something largely because everyone else is doing it.It tends to be something people talk about in the context of investing, where everyone rushes into crypto-currency because everyone else is doing it – regardless of the fact they don’t really know what it is, or why they think it will increase in value.
It’s also why they’re surprised when an asset valued entirely by speculators suddenly falls of a cliff without warning.
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It doesn’t just apply in investing either.We can find ourselves buying things we can’t afford, or applying for credit, or putting off saving into a pension, because “everyone else does it and they seem fine”.Before we made any decisions like this, we need to consider the full implications for ourselves, and not just follow the herd.
We’re affected by loss aversion too, which means we tend to be more afraid of making losses than we’re excited about potential gains.It can be one of the hurdles for new investors because they worry about investments going up and down in the short term, and overlook the fact they tend to go up over the long term.
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Once we start investing, we need to beware of a few extra biases.
There’s familiarity bias, and the tendency to assume there’s safety in the things we know.It’s why so many people invest in markets close to home, regardless of where in the world the opportunities are.
There’s also confirmation bias, where we are more likely to listen to arguments that confirm a belief we already hold.During the dotcom boom, for example, people argued that stocks weren’t overpriced if they were just measured differently.Investors who wanted to believe, bought into it, and were stung badly by the bubble bursting.
We also need to beware of recency bias, which makes us place more weight on things that have happened in the recent past, and makes us think it’s more likely to happen again.It’s why we might assume a company that has been doing well might continue to do so.
If this isn’t based on an understanding of their fundamentals, we could be making a big mistake.
Finally, there’s self-attribution.This is the assumption that things that went well were down to us, so we can replicate our success.
Going back to crypto again, it’s why people who may have bought into a crypto rally in the past could end up feeling they could do it again, when in fact there’s no way of knowing what will happen to its price.
Knowing these things are at play doesn’t make it easy to stop them affecting us.However, it allows us to question our decisions, and think carefully about whether we’re making them for the right reasons.You never know: you might not actually be hungry at 7, and have been eating breakfast at the wrong time for all these years.
Sarah Coles is a personal finance analyst at Hargreaves Lansdown and co-presents Switch Your Money On podcast.
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