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When we talk about finances , we will mostly think about numbers, math, and spreadsheets.
Most of the problems we have with our personal finances, however, are not solved on a spreadsheet, or with arithmetic or algebra, not even necessarily with numbers. They are solved by knowing our behavior in different situations, the way our brain works, our psychology .
To save successfully, for example, it is not enough to know the inflation rate and know how to calculate the amount we will need in the future. It’s also extremely important to keep our goals in mind and stay inspired to keep saving month after month.
To invest successfully, it is not enough to know the average performance of an index and make the asset allocation according to our investor profile. It is essential to know that our brain has evolved to seek immediate rewards, to avoid temporary losses, and not take into account the future. All characteristics of a terrible investor.
In addition, humans are not completely rational, we are also emotional. We are not robots, we are not spreadsheets, we feel fear, we feel anger, we feel envy.
Morgan Housel, in his book “How the Rich Think” ( The Psychology of Money in English, a much better title in my opinion) says that we should not aspire to be coldly rational when making financial decisions, but rather that we should aspire to be quite reasonable . Being reasonable is more realistic and we will have a better chance of long-term success.
I love it, because being completely rational is not achievable, not for a homo sapiens, and trying to be can have terrible repercussions.
Being rational versus being reasonable in saving
When it comes to savings we can apply this idea of being reasonable over being rational in the sense that maximizing savings sounds like the best idea, mathematically speaking. Do not spend more than necessary and save as much as we can.
Again, rationally this sounds good, but it is not realistic, it is not reasonable. Shannon Lee Simmons, author of the book ” Worry Free Money” likens it to a lettuce diet, in which the only thing you allow yourself to eat is lettuce. This is so unsustainable that eventually a family pizza will slip through you and eat it whole.
So with the savings, it is not reasonable to think that we will only spend on the most basic things all the time, that we will not buy a soft drink or a coffee, nor a screen or a cell phone. It is not sustainable, as good as it sounds mathematically. The way I see it, two things could happen. The first is that we will feel deprived, and like the lettuce diet, at some point we will spend more than we can afford. The second is that we will lose motivation to pursue salary increases (why, we will not even spend it!), And we will stagnate our professional career. It is better to be reasonable.
Being rational versus being reasonable in investments
Something similar happens with investments. Investing fully in stocks, without diversifying with more stable asset classes, can rationally generate higher returns in the long run. But investing 100% in stocks means greater volatility in our portfolio, and this volatility can cause us fear and doubts that end up leading us to make bad decisions.
If we diversify our portfolio from the beginning to also include government debt and real estate to reduce volatility, our chances of success would increase. It is better to have an average return of 10% per year for 20 years without losing sleep for a single day, than to have an average return of 30% per year only for 5 years because fear and doubt generated by high volatility made us decide not to invest plus. In the first scenario, an initial investment would have grown 5.7 times, in the second only 2.7.
Another phrase that Morgan Housel writes in his book is perfectly related to this topic:
“More than I want great returns, I want to be financially unbreakable. And if I’m steadfast I actually think I’ll get the highest returns, because I’ll be able to keep going long enough for compounding to do wonders. “
Biases to take into account
If this has convinced you that psychology is at least as important as mathematics when it comes to managing our personal finances, you may be wondering if there is something specific you should learn. That is, just as we learn mathematics or to use Excel, should we learn something about human behavior?
The truth is that a large part of the success will come more than anything from knowing yourself as an investor, knowing what inspires you to make certain purchases, what keeps you awake at night, what kinds of news usually have an important impact on your life.
For example, you could identify (especially recently) that inflation worries you, and seek to adapt your investment portfolio to this fear, so that no matter what inflation is present in the future, your investment is prepared for it.
We can learn these kinds of things by being a little more aware of our behavior around money. Some additional points that we must identify are shared by Peter Mallouk in his book “The Path” :
1. We want to follow the pack. It’s our instinct, and while that instinct served our ancestors well while hunting mammoths, it can lead an investor to panic sell when everyone else is doing it, and to over-invest in an asset just because others are too. Let’s listen to Warren Buffet and be greedy when others are afraid, and let’s be afraid when others are greedy.
2. Men are overconfident. Peter Mallouk mentions a study of 35,000 homes over 5 years, which found that the extra confidence of men resulted in 45% more activity in their investments than in the case of women. This behavior not only resulted in more commissions (which are charged for each movement) and more taxes (which are due at the time of generating profits), but also resulted in a 2.65% lower return.
3. We suffer from anchoring. Anchoring is a term psychologists use to explain the shortcuts the brain uses to reach conclusions. For example, in an experiment conducted by Campbell’s (the soup brand), they set a large discount on the price of their cans. In one scenario they did not set a limit on how many cans could be bought, while in a second scenario they set a limit of 12. When there was no defined limit, a consumer bought an average of 3.3 cans, when the limit of 12 was set, the average went up to 7! Buyers suffered from anchoring towards the number 12. This can happen when investing, that the first price we see of a stock becomes our anchor, making us believe that any price above is very expensive, and any price below is very cheap ( however uncertain this may be).
There are undoubtedly several other cognitive biases to take into account, some of which Peter Mallouk mentions in “The Path,” but I hope these are enough so that you don’t just trust your finances to math, but also include math. psychology in the equation.