Eight reasons you make bad financial decisions

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1. You are poor, tired and worn out
Why does anyone take a payday loan at 4,000% interest? Or pay £800 for a television from “rent to own” firm BrightHouse rather than buying it for £350 from John Lewis? Why buy junk food when it’s cheaper to cook at home, or waste £10 a week on lottery tickets when the
money could be used to pay off debts?

The truth is that poor people are more likely to make bad financial decisions, according to a new report from the World Bank. They borrow too much and save too little. But the report doesn’t blame the poor – it says the constant, day-to-day hard choices associated with poverty in effect “tax” an individual’s psychological and social resources, and turn them into bad decision-makers.

The World Bank cites numerous academics to back its findings – not least research from 2013 by academics Sendhil Mullainathan and Eldar Shafir – that the cognitive deficit of being preoccupied with money problems is equivalent to a loss of 13 IQ points, losing an entire night’s sleep or being a chronic alcoholic. Mullainathan and Shafir say this could explain why poorer people are more likely to make mistakes or bad decisions that exacerbate their financial difficulties.

In her 2012 blog – Why I Make Terrible Decisions, Or, Poverty Thoughts – 32-year-old Linda Tirado, who worked in two minimum wage jobs while studying at college in the US, tries to explain why she smokes, eats junk food and has no ability to plan for the future.

“Rest is a luxury for the rich,” she says, detailing a life where she had to get up at 6am and did not return home from her second job until past midnight.

“You have to understand that we know that we will never not feel tired. We will never feel hopeful. We will never get a vacation … I make a lot of poor financial decisions. None of them matter in the long term. I will never not be poor.”

When the blog went viral – it received more than half a million hits after being widely shared on Facebook – it was vilified by some critics who claimed the facts of Tirado’s life did not fit reality. But in her book Hand to Mouth, published in 2014, Tirado lays bare the knife-edge finances that families such as hers live on – where a single problem can capsize their lives and where even the best financial planning would enable them to save just £150 or so a year. It perhaps helps explain why people buy lottery tickets rather than putting the cash into an Isa.

Mullainathan and Shafir put it this way: “If you want to understand the poor, imagine yourself with your mind elsewhere. You did not sleep much the night before. You find it hard to think clearly. Self-control feels like a challenge. You are distracted and easily perturbed. And this happens every day.”

2. You fail the marshmallow test

In a 1960s psychological experiment by Stanford University, children were filmed being offered one marshmallow immediately or two later on. The researchers deliberately left the room for 15 minutes, leaving the children alone as they squirmed and struggled to defer their instant desires.

On average, the children held out for no more than three minutes, although one in three lasted the full 15 minutes, and were rewarded with two marshmallows.

In later years, the professor in charge of the experiment, Walter Mischel, found that the children least able to defer gratification were the ones most prone to poor academic achievement and with the least capacity to plan and think ahead.

Further studies suggest that it’s not innate IQ or intelligence that matters, but self-control. The crucial skill of those who deferred grabbing the marshmallows was not that they did not want to eat them, but that they managed to distract themselves from their desire (some sang songs from Sesame Street).

The financial lesson from Mischel’s research is that if you are tempted to splurge on your credit card, you have to avoid thinking about the thing you want in the first place. Maybe sing children’s songs.

3. It’s in your genes
The studies of children and deferred gratification have prompted researchers to ask if it is in your DNA. In other words, you can blame your parents if you’re the type who is unable to save or is always overdrawn. The gene most frequently cited as the one that determines financial success is catechol-O-methyltransferase, or COMT.

A study by the University of North Carolina found a variant of the COMT gene controls the level of the neurotransmitter dopamine in the cortex and is associated with a tendency to make impulsive decisions.

A separate 2012 study by Camelia Kuhnen, associate finance professor also at the University of North Carolina, found that people with variants of the COMT gene are better able to learn financial information.

Meanwhile, the Center for Neuroeconomics Studies in Los Angeles linked COMT to the success of Wall Street traders.

Oddly enough, the COMT gene has also been cited by German researchers as the “altruism gene”. A report by Bonn University says: “A minute change in the gene is associated with a significantly higher willingness to donate. People with this change gave twice as much money on average to a charitable cause as did other study subjects.”

But gene research is controversial, given the interplay of nature and nurture, and the still rudimentary understanding of how genes function. Lots of cod-science articles in newspapers will suggest, for example, that there is even a gene that makes people stingy – citing research that again names COMT.

4. You are under 53 … or over

The sweet spot for financial decision-making is at the age of 53 – either side of that we are most likely to make mistakes, such as paying too much for credit cards, failing to work out interest rates, paying too many fees and even wrongly estimating the value of one’s house.

Research by academics at Harvard University, the National University of Singapore and the Federal Reserve Board also warned that by the time people get into their 80s, around half the population suffers from dementia or other cognitive impairment, rendering them much less capable of making important financial choices.

One study found that financial literacy scores decline by about 1% a year after the age of 60. But while half of those in their 80s realise they need help with their finances and get it, the other half don’t, according to the Center for Retirement Research at Boston College.

Meanwhile, the English Longitudinal Study of Ageing tested memory and numeric problem solving among men over the age of 50. It found that their abilities remain stable until 60-64, but then begin to decline. On average, their ability to recall numbers will have declined by about 30% by the age of 80.

5. You are no good at maths

A bat and a ball cost £1.10 in total. The bat costs £1 more than the ball. How much does each cost? If you’re like most people, you’ll say the bat cost £1 and the ball 10p. The correct answer is the bat is £1.05 and the ball is 5p. It’s a typical example of how people wrongly assess numeric information and, as a result, are drawn into making incorrect financial decisions. It’s also why retailers use multiple discount offers that confuse shoppers into spending more than they were expecting.

Classical economics assumes that participants in markets behave rationally, when the reality can be different. Money matters are too complex to deal with at once, and too interconnected to break down, researchers say. Unsurprisingly, we cannot hold a complete picture of our financial situation in our heads all the time. Our solution is to divide our finances and deal with each aspect separately.

It is a rational response to handling complexity, but because our finances are so interconnected, breaking them down leads to irrational choices.

Nick Chater, professor of behavioural science at Warwick Business School, says this means people will tend to borrow on a credit card while elsewhere they have a pot of savings. “An economist would say that’s nonsense,” he says, “because you should look at your overall net position and manage that efficiently, which would mean you pay your credit card debt with your savings. But that’s not the way we think.”

6. You don’t know when you are going to die
The biggest financial decision most people take in their life is buying a property and taking out a mortgage. But the second biggest is arranging their pension, in an era when companies have abandoned secure final salary-based schemes.

The new “pension freedoms” leave it up to individuals to manage their money through retirement, with all the risks that entails. The biggest unknown is how long the money has to last as we don’t know when we will die and are generally clueless about our life expectancy.

Research by pensions firm MGM Advantage in 2014 found that the average worker approaching retirement age underestimates how long they will live for by between five and 10 years. Data from the Office for National Statistics suggests that the average British male will live to 86 and the average woman to 89. But men in the study thought they would live to 81, while women were lower, at 79.

Plenty of other research also indicates that younger individuals drastically underestimate how much they will need to save to pay for a decent retirement.

There is help, though, of a sort. A variety of longevity calculators exist on the internet, although they vary in quality. Ones worth trying include the calculator from Confused.com, and the neatly named Death Clock at death-clock.org.

The trouble is, if you get a clearer picture of how long you are going to live, you then have to finance it. Annuity rates are so low that you need £250,000 at 65 just to buy an income of £15,000 a year. But that compares with average savings at retirement that are currently a paltry £40,000.

7. You can’t cope with choice and complexity

Given that decisions are driven by comparing all the available options, having too many options makes it difficult to make a choice.

A study at Columbia University in 2000 revealed that we cannot function when given too many options. It invited people into a laboratory and asked them to choose a jar of jam to take home for free. One group had three jars to choose from, one had four and one had 20. Those with a small selection made reasoned and logical decisions based on sensible preferences. However, those with 20 jars were unable to do so. They became overwhelmed and ended up making snap decisions.

We suffer the same thing when faced with financial questions, and the most common coping mechanism is to make no decision at all. Chater says most people simply fall back on whatever they did last time.

When people select an investment, they will consider their risk tolerance. But as Chater explains: “This isn’t an absolute calculation, it’s a relative one. It means we’ll look at the range of options available and if we consider ourselves risk averse, we’ll pick something from the less risky end of the spectrum.

“However, if you give the same person a different list of options, they’d still pick something from the less risky end of the range. They think – ‘Here’s the range, I don’t like risk, so I’ll go towards the bottom of that range’. They don’t care what the range is.”

8. You do what everyone else is doing
When forced to make a decision for which there is no precedent, our go-to solution is to look at what other people are doing. The herd mentality makes an awful lot of sense in any number of practical situations, but not when it comes to our finances.

Richard Taffler, a professor of finance at Warwick Business School, says that when people are choosing where to invest, they won’t systematically think about all the options. Instead, they will consider what other people are investing in.

Similarly, if everyone around us is borrowing on credit cards and putting off paying into a pension, we take comfort from the fact we are doing the same things as everyone else. We don’t stop to consider whether everyone else is right.

Sources : Thegardian

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