The psychology of money is not rational. Although we know we should set some money aside every paycheck, we don't.
Most people know a budget is important, but who follows one? Often, our money behavior causes hurt or shame. We’ve all wondered how our behavior affects our personal finances.
Personal finance is dependent upon your behavior because your emotions, beliefs, values, and cognitive biases shape your financial decisions, often leading to irrational choices that can negatively impact your financial well-being.
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A good credit score does matter.
Credit scores influence lenders in determining your creditworthiness. It’s the difference between buying a house and renting. The higher a credit score is, the more likely you are to receive good terms on credit cards, car loans, and home mortgages.
Sound personal finance can dictate how you live. And it dictates your credit score. That's why responsible financial behavior is so vital. We'll discuss how your financial behaviors influence your finances. We'll also look at how you can change it.
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How you handle and plan for your money is the hallmark of personal finance and it shapes your financial future. There are some fundamentals that you must have, and emotions often affect these basics. Without these pillars, your financial health is built on sand.
As boring as this one is, setting a budget is important. How will you meet your financial goals if you don't know what you have? A budget lets you see what you have and what you don't have. Steps to creating a budget include:
A budget forecasts expenses and income. It also sets your achievable financial goals. It’s the bedrock of your finances.
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Making a conscious effort to put money away is imperative. It needs to be done in a systematic manner.
Reasons to save include:
This is your personal finance safety net.
Saving takes discipline, and your behavior dictates how you approach it.
You can read this post to learn more about emergency funds which I discussed on MoneyHawk a few days ago.
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This is where you go beyond saving. Saving preserves your money, but investing helps it grow. Investing encompasses
When you invest wisely, it helps you in achieving financial stability. But be aware investing is not a get-rich-quick scheme. You'll have to have patience and be in it for the long term. There’s always risk with reward when it comes to investing.
If you have no idea about investing in real estate, you must read this post on MoneyHawk that’ll give you some basic ideas on the topic.
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Just like a ship can’t be steered without a destination, neither can your finances. Determine what your goals are.
Whether you want to retire early or buy a house without a specific goal, you can drift aimlessly. Think short-term and long-term when developing goals.
Your behavior plays a significant role when it comes to these financial necessities which eventually decides what your financial success may look like.
Just a few days I have shared a detailed guide on the basics of personal finance. Do take a look at it If you want to know more.
Personal finance behavior reflects several things. They include:
Your personal finance includes all your actions regarding the basics of financial health. Personal finance varies according to many factors, but it starts with your relationship with money.
Money is more than just a way to purchase goods and services. It also has emotional and, to a certain extent, symbolic meanings.
Money can represent:
You need to think of money as an entity with which you have a complex relationship with. Your money is not a fixed entity. Money is something you have feelings about. You interact with it, and it provides challenges and opportunities.
It's essential to understand the emotions surrounding money. The most prevalent and important emotions are:
Understanding that these emotions are connected to your financial decisions is vital. If you aren't aware of them, they could override rational thinking. Bad decisions are then made.
Because there is an emotional connection to money, it often influences financial behavior. For example, someone who links money to love may spend it on lavish gifts to win affection. A person needing security may be a saver and avoid investing with its potential risks.
Emotions can motivate you to make unnecessary or impulsive purchases. But there are also societal pressures that could pressure you to spend and live beyond your means. This is where the “keeping up with the Joneses” comes from.
Emotions can also lead to over-optimism when it comes to investments.
Personal finance is dependent on your behavior. Managing these emotions is vital for making sound decisions.
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Knowing your money personality trait can help you build a solid personal finance plan. There are five common money personalities.
They are:
Investors are consciously aware of their money. They know what they have and want to put it to work. Their financial actions are driven by careful decision-making. Investors know they need to take a certain amount of risk, but they seek a day when their passive investments will provide income to cover their bills.
Savers are conservative and don’t take financial risks. They’re the ones who turn the light out when they leave a room.
Savers usually either don’t use credit cards or pay them off every month. They are always tucking something away for a rainy day.
Big spenders are the opposite of savers. They always try to make a statement and love gadgets and nice clothing. They aren't usually bargain shoppers.
You've heard of keeping up with the Joneses. The big spenders are the Joneses. Big spenders don't fear debt and will take risks with their money.
Debtors don’t try to make a statement with their buying. They don’t spend much time thinking about or tracking money. Debtors just spend what they earn. Often, spend more than they earn.
Shoppers get great emotional satisfaction from spending money. They happily look for bargains. Shoppers are aware of the potential for debt. However, besides spending, they invest in various forms. Some have 401 (k) plans.
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We know that psychological factors influence our financial behavior. But, Cognitive biases also weigh in on how you spend or hold money.
A cognitive bias is a systematic error in thinking that can occur when people are interpreting and processing information. The error is that the outcome of the thinking isn’t plausible or logical. There are several different types of cognitive bias.
Confirmation bias is common in personal finance. This is where individuals make it a point to look for and find information that confirms their pre-existing beliefs. The proverbial “yes man” is what they seek.
If they think a stock should do well, they research until they find something that says it will. Never mind all the information that said it wouldn’t. They found something that confirmed their bias.
Anchoring bias occurs when an individual relies heavily on the initial piece of information when making subsequent financial decisions.
They get stuck on the first step of a staircase. For example, if someone hears that a stock is trading at $200, they may see any other price for that stock as too high or too low. They can’t adjust their thinking.
Availability bias causes people to rely on easily accessible information. They don’t consider a broader range of options.
It's like going to the same store every week because it's nearby. However, other stores further away may have better or less expensive products.
Availability bias potentially leads to missed financial opportunities. It can also lead to more risks.
Long aversion bias is a tendency to prefer avoiding losses over acquiring gains. You're always on the defense. It equates to staying on a sinking ship. You should be jumping in the lifeboat.
This bias leads to irrational decisions which often results in poor financial decisions. You may hold onto losing investments for too long or sell winners too early.
The framing effect is all about the information’s original presentation. It can be smoke and mirrors because the way the information is presented influences decision-making. You only hear one side of the story.
In the framing effect, the potential gains of the opportunity are focused on, and the possible risks are not discussed.
Sam Bankman-Fried targeted those people with the framing effect. He then swindled thousands of people who fell for his pie-in-the-sky offer with no risk presentation.
It’s necessary to outsmart yourself when it comes to cognitive bias. It’s like a game of mental chess. But there are ways to overcome this and make rational financial decisions.
You must first re-read the last section and become aware of your biases. By recognizing cognitive biases, you can defeat them and mitigate their influence.
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A powerful strategy for overcoming cognitive bias is to seek diverse perspectives and information. If you actively seek out various viewpoints you can challenge your belief system and make more objective decisions.
Many investors who didn’t seek out various viewpoints fell for Bernie Madoff’s Ponzi scheme.
There’s no hurry. Take the time to make decisions. If you’re in a situation where you must act fast: stop. You need to process the information and weigh the pros and cons.
If you rush a decision, your biases will rear their ugly heads and the result will be poor financial outcomes.
Arm yourself with knowledge of financial education by doing thorough research and analysis. This will keep you from making impulse decisions. Gathering and processing information will help you make sound financial decisions.
So, take the time to:
Knowledge is power and it’s a shield to potential financial losses.
Don't overlook the need for sound financial advice from a qualified financial advisor. This is not your brother-in-law or best friend, but someone who's in the trenches and knowledgeable.
A financial advisor offers objective guidance. They help you avoid your cognitive biases. They will help you make informed decisions.
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Many decisions concerning investing are influenced by:
These can lead to irrational decisions. Some of these could be by buying high or selling low. You’re always chasing the next “hot” investment. You may be one who succumbs to the herd mentality.
Investing requires financial discipline, patience, and a strategic approach. You must be guided by objective analysis, not emotions or biases.
The way you were raised affects how you handle your current finances. If you grew up in a house with little money you might be nervous about not having enough. That could make you a saver.
But if your parents always spend money like going out for expensive vacations, or buying luxury items like expensive rings, you might follow suit.
Look at how you were raised and compare it to your current spending and saving habits.
Cultural norms concerning money can shape your financial behavior. In some cultures, discussing finances with friends or family is taboo. Often this leads to feelings of embarrassment or shame about financial members.
Many with this cultural attitude don't seek out financial advice, even when they need it the most.
There's also a strain on finances because, in many cultures, helping extended family is necessary.
There are several significant consequences to poor financial behavior. These consequences could be the difference between living a prosperous life or living paycheck to paycheck while staring down debt. Here are a few.
Poor behavior can make it easy to fall into the trap of irresponsibly using credit cards. By doing this you don’t consider the long-term effect this will have on your finances.
There are high-interest rates and hidden fees, which can add up quickly and leave you with debt that's hard to pay off.
You may find yourself in a situation where you are having problems making minimum payments. This can lead to missed payments and cause stress.
Debt due to poor behavior can negatively impact your quality of life.
A strong credit score is vital for your financial reputation. A low credit score has far-reaching consequences.
That mortgage for your dream home may be out of the question if you’ve allowed your behavior to destroy your credit score.
Even landlords check credit scores when renting apartments. Finding a place to live may be difficult.
The first step is to set financial goals. Without clear goals, it can be difficult to stay motivated and work toward better financial habits. Ensure you prioritize goals. If debt is the problem, set a date when you want it paid off entirely. Prioritize which credit card you pay off first.
Maybe you want to save up for a home down payment. Whatever your goals are, make sure they are realistic, or you’ll find yourself abandoning them and going back to old habits.
Create a budget and stick to it. A budget will help you identify where you’re overspending. You’ll be able to allocate resources to apply to your goals. And eliminate those expenses that hinder you in reaching your goals.
Keep in mind that the price of that morning coffee you’re buying daily adds up and can be used for other items on your wish list. Take a to-go cup instead.
Developing a savings plan is a big part of changing your financial behavior. You’ll be able to handle unexpected expenses like car repair. Or you could save up for that new car.
Don’t be afraid to seek professional help. You could talk to a:
They can help you identify where your problems lie and how you can correct them. A financial coach may also be the ticket.
This post on inflation may give you new info which you might not be aware of till now and it’ll surely help you save money as well investing.
You now know how your behavior affects your personal finances. It can greatly impact whether you’re a spender or a shopper. But you might have additional questions. Here are a few we found most people have.
It starts with creating a budget. Tracking your income and expenses will help you determine how much you can put aside. Once you've determined this, discipline comes into play. Don't spend it but put it in your savings account.
Look for a bank that’s FDIC-insured. Your savings will be safe, up to $250,000. You also want to look at the interest rates. High-yield interest rates are often found on online banks.
As long as the online bank is FDIC-insured it is safe. You give up brick-and-mortar branches with an online bank, but the convenience of online banking should make up for that. Most online banks have high-yield interest rates on their savings and checking accounts.
There's a direct correlation between your behavior and your financial well-being. Cognitive biases will sabotage how you make decisions regarding your finances.
Watch out for family and peer influences that may have negative effects.
Remember that there are consequences to letting your emotions interfere with rational decisions about your personal finances.
