What’s that? You didn’t realize your brain is the enemy.
I didn’t either.
Once I realized this, it made life easier.
I was done working against my natural tendencies. I could now rewire my brain for financial success.
Below are 4 examples of financial mistakes which are natural tendencies of all humans. Also, how to prevent these mistakes.
Mistake # 1 – Mental Accounting
Definition: Tendency for man to divide money into separate accounts based on subjective criteria.
Typical Example: Treating a $100 you received as a gift from Grandma, differently than a $100 bill earned.
Typical Example # 2: Having money in a savings account earning .25%, with high-interest debt to pay off at 12%.
Cure: Funnel income, no matter the source, into one savings account.
Any “found money”, such as a tax refund or gift from Grandma, quickly decide where that money is best utilized.
As for expenses, occasionally change how you pay. If you always pay with a credit card, try cash.
Mistake # 2 – Price Anchoring
Definition: Man’s tendency to relate the value of a purchase to a price point that rationally should have no bearing on amount spent.
Typical Example: The “rule of thumb” to spend two months’ salary on an engagement ring.
Typical Example # 2: A Realtor will tell you that in 2007 this house was going for $500,000 and is now listed at only $350,000. Causing you to think this house is undervalued.
Cure: For big ticket purchases like a house, car, or engagement ring, ask a friend whose financial values you respect for their input.
For everyday purchases, avoid looking at the MSRP or sticker price.
- Can I afford this today?
- What do I really want to spend?
- What are some alternatives?
Mistake # 3 – Loss Aversion
Definition: Man’s tendency to avoid loss, rather than acquire gain.
Typical Example # 1: An investor is more likely to sell a stock that has increased in value, rather than selling stock that decreased. Overtime, his investment portfolio is made up of investments that have decreased.
Cure: Don’t think of selling a stock for less then you paid for as a loss. It’s a gain for two reasons:
- Tax deduction
- You can better utilize that money elsewhere
Don’t check your portfolio often. If you don’t know you’ve lost money, you don’t experience the pain.
Since stock prices go up in the long-run, the longer you go without looking at your portfolio, the greater chance of seeing a gain.
When trying to change a behavior, such as paying off debt, tell your 3 closest friends. Make a fake contract, sign your name at the bottom, and then email it to them. The pain you would incur from breaking that contract is high relative to the pain if you went about it alone.
Mistake # 4 – Herd Behavior
Definition: The tendency for man to want to do the same thing as a large group of other men, with no thought if that action is rational or irrational.
Typical Example # 1: Buying when prices are high because everyone else is.
Typical Example # 2: Selling when prices are low because everyone else is.
Cure: Warren Buffett said, “Be fearful when others are greedy and greedy when others are fearful.”
Keep this in mind when making your next financial decision. If everyone is telling you to buy this or buy that (i.e. gold, silver, real estate) do the opposite.
In the financial world, if it’s too good to be true, it usually is.
Also, write up an investment policy statement or contract.
Include factors such as:
- Investment objective
- Investment goals
- Desired asset allocation and diversification
- Summary of your risk tolerance
- Rebalancing schedule
Before making any changes, consult with this contract.
In the comments, have you made any of these mistakes? Please share along with how you’ve prevented from taking place a second time.
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