Afraid of Making Poor Money Moves? Use Psychology to Predict Your Financial Behavior
Worried about your human nature working against you when investing? Here's how you can avoid making poor money moves before you make them.
This story originally appeared on MarketBeat
It's always fun to use "reverse" psychology on your kids: "Don't you dare clean your room!" Sure enough, they run up the stairs, laughing hysterically, to make their beds and shove half of their toys in the closet.
If only it was that easy with money: "Don't you dare spend too little this month!"
The psychology of financial planning has become a new topic for the Certified Financial Planner Board of Standards. The CFP Board added the category to its eight principal knowledge topics for 2021 and it will even crop up in the certification exam starting next year.
Psychology in financial planning involves combining traditional advice with elements of behavioral finance to strengthen client relationships.
The experts know what you might do before you do it, so what if you could predict your own financial behavior ahead of time? That way, you can intervene on your behalf before you go into debt or veer off toward another ill-advised direction with your money.
How You Can Use Psychology to Predict Your Own Behavior
You can use psychology to predict your own behavior ahead of time. Seems weird, right? Well not really, because understanding the types of psychological behaviors common among investors can help you make better investing decisions.
Let's take a look at how you might attempt to predict your own behavior with three main tips.
Tip 1: Know psychological principles related to investing.
The more you research various psychological principles related to investing, you may find yourself more aware of your own behavior.
In general, humans are a confident bunch. Confidence can lead to biased investing decisions. For example, you may believe that you understand financial markets or specific investments really well and don't take care to analyze data and expert advice. Overconfident investors also believe they have more control over their investments than they actually do. (Experts also overestimate their own abilities to pick stocks.)
We like things with which we're familiar. It's why we choose McDonald's over a wonderful local restaurant when we find ourselves in a new town. The familiarity bias in investing refers to when investors invest in what they know, such as domestic companies or companies you hear about all the time. For example, you may feel compelled to invest in Kraft Heinz Co. because you're familiar with the blue boxes of mac n' cheese in the grocery store.
Gambler's fallacy leads you to erroneously believe that a positive event will occur after a string of negative events, or vice versa. It's the "it can only go up from here!" phenomenon. Believing a stock will lose or gain value after trading can cause you to make the wrong decisions. But the truth is, nobody knows what will happen in trading from day to day.
Confirmation bias refers to our propensity to seek information that confirms what we already believe. Getting information about a particular stock can confirm our decision to invest in it. Have you ever felt a compulsion to invest in a particular stock, then keep reading information about why you should invest in it to confirm your own bias? When Elon Musk tweets about Dogecoin, this could lead to a confirmation that you, too, should purchase Dogecoin.
Now, do these four types of biases represent the full list of psychological principles of investing? Hardly. You can learn about dozens more, and it's a great idea, because the more you know about all of them, the more likely you'll avoid them yourself.
Tip 2: Assume that you'll fall prey to one or all financial biases.
Just like a puppy on a too-long leash, you're better off assuming that you'll make mistakes. Otherwise, you go into investing with an overconfident mindset from the get-go.
Remember, though, that it's okay to make small mistakes — regretting investing in a particular stock, not paying off credit card debt earlier, not researching a particular stock the way you should have — it happens.
However, do you know the top regret that most investors have? Magnify Money's survey found that the top investment regret is not investing at all, or at least not investing earlier. So, invest anyway, and take heart that you'll make a mistake or two. It's okay, as long as you invest.
Tip 3: Get outside advice.
Going it alone can feel… well, lonely. A good financial advisor can point out where you're falling prey to specific psychological principles. When you choose a reputable financial advisor and choose options that meet your risk horizon and investment objectives, you can maximize your financial performance in the long run. Treat choosing an investment advisor like a job interview. Make sure your personalities click and don't forget to ask the following questions:
- Are you a fiduciary? (A fiduciary works in your best interests.)
- How do you get paid? (You want a fee-only financial advisor.)
- How much will you charge? (Watch out for fees — they can cost you a bundle.)
- What are your qualifications? What certifications do you have?
- How would you describe your role as a financial advisor?
- Where and how do you suggest investing my money?
- Who is your custodian? (Steer clear of anyone who acts as his or her own custodian. Remember Bernie Madoff?)
- How do you use psychological principles when working with your clients? (Many financial advisors have started putting a focus on psychology in financial planning, so asking this question can allow you to rest assured that your financial advisor has your financial and psychological health covered.)
You may be tempted to consider a robo-advisor in lieu of a human financial advisor, but if you think you're at risk of making poor money moves or letting biases get the best of you, a financial advisor can keep you grounded.
Know the Risks You Face Ahead of Time
Trying to determine the financial mistakes you'll make ahead of time may seem like a pessimistic point of view to take, but it's important to know your limitations. Knowing the risks ahead of time can cure erroneous assumptions prior to investing. Knowing that you're human can limit those errors and help secure your financial future.