Personal Finance

The Danger In What You Think You Know About Money

When it comes to making decisions, it’s tempting to think that we are always operating from a place of sound judgment. It’s those other people who don’t know what they are doing, right? Well, as divided as we may be about money or anything else, the reality is that all our brains are wired in a way that makes quick decision-making easy and sound decision-making a slower, more energy-consuming task.

No one has done a better job illustrating this than Daniel Kahneman in his ubiquitous book Thinking Fast and Slow. In it, he describes the two systems of our brains: the instinct-driven system and the logical thinking system. The instinct-driven system is working all the time, governing everything from making sure we breathe to crossing the street when a scary person walks in our direction. The logical thinking system is used more judiciously, which is an attempt by our body to conserve energy, as analytical thought requires more juice.

I sometimes like to imagine these two systems as an assistant and a boss. The boss outsources as many of the routine tasks as possible and only takes over for the assistant on the complex work. The assistant doesn’t do critical thinking; he relies on patterns, mental shortcuts, and gut feelings to get things done. This leveraging of effort works exceptionally well most of the time but sometimes decisions are made quickly by the assistant when they should have been made more diligently by the boss.

The challenge is that there is not always a clear way of identifying which decisions are worthy of being made by management. The instinct-driven mind often thinks it has made a good decision when it hasn’t. As Kahneman puts it, this part of our brain is “a storyteller. It tells the best stories that it can from the information available, even when the information is sparse or unreliable. And that makes stories that are based on very different qualities of evidence equally compelling.”

If a story feels true, the assistant is likely to believe it without considering whether he has all the information needed to draw that conclusion. The boss would be the one to consider all the facts, known and unknown, but that’s no help if she wasn’t part of the decision-making process.

The nature of our minds is to believe that we have all the information that is relevant and important to a decision even when we don’t. This thinking error, or cognitive bias, is referred to by Kahneman as “What You See Is All There Is” and it can lead to partially unfounded beliefs and less than optimal financial choices. Consider these examples:

Overspending

When we want to keep up with the lifestyle of our peers, we might spend money we don’t have. What we see is everyone we know buying a new home, car, handbag, or other fodder for bragging on social media. What we don’t see is their credit card bill, bank balance, or credit score. This can result in unrealistic ideas about what is affordable that lead to detrimental spending decisions.

Disappearing Wealth

Wealth is often spent down when it is passed to the next generation. What we see is the first generation’s desirable lifestyle, vacations, homes, and success. What we don’t see is the hard work, sacrifices, and planning it took to accumulate the money. This can result in a misunderstanding of how to gain and maintain wealth.

Impulse Investing

We might rush into an endeavor or an investment with the idea it will be easy money. What we see is the real estate market booming and people selling houses for much more than they were worth a few years ago. What we don’t see is the average long-term growth rate of real estate, the tax implications of a quick sale, or the time, expertise, and money it takes to remodel a rundown property. This can result in overconfidence about the outcome of an investment, increased risk-taking, and a higher likelihood of losing money. (I’m looking at you, meme stocks.)

Overcorrecting

When we witness someone else experiencing a bad financial outcome, we might do the exact opposite of what they did. What we see is a parent who lost their money in the market right before retirement, causing them to work well into their later years. What we don’t see is that staying out of the market can cause its own set of problems like losing purchasing power to inflation and sacrificing growth that could help us retire earlier. This can result in different but similarly negative financial outcomes despite our best efforts to keep the past from repeating itself.

Underestimating Ourselves

Sometimes success looks so unattainable that we don’t even try. What we see is a highly successful entrepreneur who has everything we want. What we don’t see is that he started out in an entry-level position and that it took him decades of schooling and work experience to get where he is. This can result in distorted beliefs about our own abilities that keep us from realizing our full earnings potential.

There are countless ways that seeing only part of the picture can negatively influence our decision-making but unfortunately, we can’t simply rewire our brains to see its blind spots. What we can do is be mindful of what we pay attention to and what we share with others. Rather than the what, we can focus on the how: how she saved for a year to buy that handbag, how they worked two jobs to save money for their children, how he put 100 hours into remodeling a house before selling it for a profit, how grandpa lost his money putting all his eggs in one basket and how that CEO invested in himself for years before it paid off. We can choose to focus on process rather than results.

If our brain wants a story, let’s give it one about the journey, not the destination.

Checkout latest world news below links :
World News || Latest News || U.S. News

Source link

Back to top button
SoundCloud To Mp3