Everyone wants to make smart financial decisions, but unfortunately, people often make mistakes with money as a result of advice that has been ingrained in them over the years — without taking into account their overall financial picture.
Think back to when you were a child. Do you remember hearing your parents talk about money, or lack thereof? What was your experience with money as a child? Did you save or spend every penny you received? There is a term called “behavioral finance” that uses psychology to understand why individuals make the financial decisions they do. Here are three behaviors to avoid that are often a result of how money was discussed with you as a child:
1. Mental Accounting
Mental accounting is when you separate finances into different categories. We all do this. For example, you have probably been told to have funds earmarked for different goals — retirement, education, emergencies, etc. The problem occurs when you are so focused on these individual categories that you are not seeing how they affect one another, as well as your overall financial picture.
For example, you may be concentrating on adding to your emergency fund in an account paying 1 percent, but you are carrying a balance on a credit card with an interest rate of 12 percent. Another example is contributing to your retirement account each year, yet treating your income tax refund as found money. Both of these situations, while approached with good intentions, do not necessarily help you out in the big picture financially.
2. Throwing Good Money After Bad Money
This is a bias in which people are unable to accept that they have already invested in a poor financial decision. This bias prevents them from making the rational decision to stop investing additional money there in order to try to rectify a useless situation.
An example of throwing good money after bad money would be if you purchased a used car to be frugal, but then found you had to make $500 in repairs soon after. Do you make the repairs instead of giving up that car entirely? You want to make financial decisions not only based on what the asset it worth now, but also what the asset will potentially produce in the future. This is true whether it is your car, house, investments, etc.
3. Procrastinating on Financial Decisions
One of the main obstacles to planning effectively for long-term financial goals is procrastination. People sometimes have a tendency to put off making important financial decisions due to a lack of confidence from their financial situations growing up. Typically, this lack of self-assurance is due to the overwhelming fear of making a mistake. In this situation, you can easily overcome this bias by educating yourself. Try enrolling in financial classes or workshops. If you feel you need more guidance, consider hiring a financial planning professional.
Do any of these three financial mistakes sound familiar to you? If so, the good news is by recognizing and understanding these biases, you can control them to avoid making poor financial decisions in the future. The next time you face a big decision about your finances, stop and ask yourself, “Am I making this decision based on sound information, or am I allowing my biases to get in the way?”
Pamela Plick is a member of the DailyWorth Connect program. Read more about the program here.