Dear Diary, I made it to a barber shop. Short...
Singer Rihanna once nearly went broke after overspending and sued her financial advisor. The advisor was puzzled: “Was it really necessary to tell her that if you spend money on things, you will end up with the things and not the money?”
The truth is, yes, we need to be told that. As obvious as this might be, we seem to be unable to act accordingly. When we say, we want to be a millionaire, we most of the time mean that we want to spend a million. Which is, let’s face it, the exact opposite of being a millionaire.
True wealth is invisible. It’s the freedom to choose where you work, how much you work, with whom you work and when to stop working. It’s not a luxury car, living a big house or the ability to post amazing vacation pics on Instagram. Most of us can only afford this by working more, getting a higher paycheck, and climbing up the career ladder. True wealth is a fund, an account, a spread sheet. When left alone well enough our money in that fund does compound like crazy and helps us live when we don’t have an active income anymore.
The rational parts of our brains understand these principles perfectly well. So why do we still fail to act on them? This is where the psychology of money comes in.
In our ancient animal brain, we are hard wired to act irrational. When we sense danger, we need to act. When we want something, we want it now. And we believe that we need to have today’s active income for at least another twenty years to be financially free. We just can’t predict how powerful compounding really is. Or as Physicist Albert Bartlett said: “The greatest shortcoming of the human race is our inability to understand the exponential function.”
Therefore, our money behaviors are mostly messed up. And most of our money mess ups fall into one of these four biases:
When our emotions kick in hard our brains stop functioning properly. Ever been madly in love? Then you know exactly what we are talking about. When it comes to money, mainly two emotions get us out of control: fear and greed. Fear makes us do dumb things like selling all our assets when the markets crash. Greed makes us do dumb things like investing in a company AFTER it went up like crazy because we want to be in. Guess what usually happens after a hype? Exactly…they fall. And then fear kicks in and we repeat it all over again.
That’s a tricky one because it comes in many shapes and colors. When managing our personal finances conservatism basically means sticking to the status quo. As in doing nothing. Like not investing. We can be that smart, successful professional who just doesn’t find the time to take care of their personal finances and pile up bonuses in a savings account. Or we have inherited this unsuccessful fund and just never rebalance it (it was money we didn’t have before anyway, right?). Or we never invested in stocks and ETF before and therefore never start it either. Or we do invest but only in our home country market and therefore are in a higher risk of low profits or losses (better than doing nothing, right?). Our very human tendency towards conservatism also is a very strong partner when it comes to building true wealth: once we developed a plan, a well-diversified investment strategy and automated it, it is the best idea to never change it again. That’s how Warren Buffett built his fortune of billions. It really is that simple. Not billions maybe but building up a healthy fortune however big your pockets may be.
We as humans are wired to turn our heads towards movement, change, noise, alarm. What helped us survive in the savannah is a hot mess in today’s noisy internet empowered information overload. Buy this! Do that! You don’t do crypto yet? Give me all your money and I’ll make you rich! Everyone is doing that! You will lose all! The next crash is coming. You get the idea…. If we are prone to the attention bias, we tend to act on every information we get. And that’s a lot. So, we go in and out, buy and sell, or change our strategy all the time.
Some of us even hand over our brains and pockets to mediocre advisors or even scammers. Don’t feel bad, it happened to the best of us.
This one is the mess up for the money experts among us. The savvy investors and financially smarter than average folks. We know that practically no active investor outperforms the benchmark index, but we still think we can beat the market. We will find a smarter approach, outsmart the crowd. How does it look like when we suffer from this bias? We are maybe an investment fund manager that beat the S&P 500 or the MSCI World a couple of years and now we, and unfortunately everyone around us, believe we will do it again and again. Except we won’t. Or we are an expert in one industry and think we understand it better than most – probably true. And therefore, will invest more successfully in that industry – most probably not true.
So, into what category falls your money mess up?
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