Use Human Nature to Help Your Finances, Not Hinder Them

Investing
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By Brian McCann

Learn more about Brian on NerdWallet’s Ask an Advisor

As a species, humans are woefully ill-equipped to be successful with their finances.

Thousand of years of evolution on the savannah have given us a host of instincts that kept us alive. Those same instincts have a tendency to trip us up when it comes to financial decisions. The list is long and illustrious and includes stunners such as:

  • the “fight or flight” instinct, which leads us to often sell our investments at just the wrong time.
  • loss aversion that makes us hold our losers, hoping they will bounce back.
  • herding behavior, which has us buying and doing what everyone else is buying or doing because, hey, that’s what the cool kids are doing.

When you couple this with the average person’s stunning lack of knowledge about basic statistics and probability, it often leads to a financial train wreck.

Fortunately some of these biases can be used to our advantage. One of the key challenges for most people in meeting their financial goals is the discipline required over time. This works against another powerful bias: instant gratification. Here are three behavioral biases we can use to help fight off the effects of instant gratification and meet our long-term goals:

Commitment Bias: We have a tendency to want to follow through on commitments we make – even if they are just to ourselves. Politicians rely on this when you pick a political party. You can use this to make sure that you follow through on your goals. Simply write down your financial goal and the steps that you intend to take to get there. This can be a powerful mental support to taking action.

Mental Accounting: Humans have a tendency to put things in easy-to-understand buckets. This applies to our finances as well. That’s why your general account for weekly or monthly expenses is spent by the end of the month.

To help meet your goals you can use this to your advantage. Set up specific accounts for specific goals: retirement, college saving, wedding fund, you name it. Then fund it automatically from your paycheck. Once your money goes into the account you have labeled “Trip Around the World Fund,” you are much less likely to spend it on a cosmo at happy hour.

Certain tax-advantaged accounts like 401(k)s and 529 plans serve wonderfully for this purpose. In addition to the mental accounting involved, they also come with tax benefits and penalties that make using the funds for something other than their intended purpose more difficult.

Social Proof: Humans are a social species. We evolved in cooperative societies, and it is hard-wired into us to look for the support of a group. We have a tendency to behave the way people expect in a given situation. That’s why group weight-loss systems are more successful than other weight-loss techniques. If you share your goal with friends and family that you trust, you will be more likely to follow through. And they can help you when the going gets tough.

You can use these three behavior biases together for a compounding affect: 1) write down your goal and what you want to do to get there; 2) set up a specific account and fund it automatically; 3) share with close friends and family what you are trying to do. If you combine these three components, it can have an explosive effect in helping you achieve your goals.