Three Behavioural Blind Spots That Induce Ineffective Financial Decisions

Making decisions related to money is at the heart of financial planning. It is aimed at making decisions that facilitate and optimise lasting satisfaction. It is an exercise that is meant to be centred around rationality. But it is carried out by human beings. And we are predominantly emotional by nature. Psychology and behaviour therefore pervasively impact money decisions and financial planning. These factors give rise to three major behavioural blind spots. They inhibit our ability to make effective money decisions. Therefore today I am going to talk about some of these blind spots and ways to get around them. 

Overestimating The Intensity Of Our Emotions 

Studies on human psychology have shown that we are bad at discerning the things that make a meaningful difference to our lives. They have also shown that we tend to overestimate the intensity of our future emotions. In the context of financial planning, this tendency causes us to associate disproportionate amounts of happiness with the achievement of our financial goals. This is especially true in case of aspirational goals such as buying a house, buying a vehicle, vacations and so on. 

We may therefore prioritise such goals over more important goals such as retirement planning or funding our children’s higher education. But this ignores another basic human psychological tendency. Human beings return to a state of emotional equilibrium reasonably quickly after a spike in emotions. The heightened pleasure caused by any event is therefore likely to be short lived. This means that we may experience a burst of happiness immediately after achieving an aspirational goal. 

But it would likely die down quite quickly in the near future. This is known as hedonic adaptation. Prioritising aspirational goals does not usually help us derive an optimal amount of satisfaction over the long term. Essential financial goals such as planning for retirement and our child's education must be given greater priority than our aspirational goals. 

Not Understanding The Relationship Between Spending And Satisfaction 

The end goal of financial planning is to optimise genuine satisfaction and fulfilment. Spending money is the means through which this end goal is achieved. Spending towards different needs of life offers varying levels of satisfaction. An individual's needs for money can be classified into 4 categories. These are survival and material comforts, experiences, autonomy and security. Jonathan Clements, an American financial educator has explained these needs in the form of a four layer pyramid as follows : 

Survival And Material Comforts : This layer includes living and discretionary expenses. These are the easiest needs to meet. They therefore provide a limited amount of genuine satisfaction. They form the base of the 4 layer pyramid. 

Experiences : These needs essentially include big ticket discretionary expenses like vacations for instance. They also include money one spends on developing their skills. Meeting these needs leaves the individual with a lasting impact in terms of an experience or skill development. Meeting these needs is more challenging. It therefore provides a greater degree of lasting satisfaction relative to those met in level 1. This forms level 2 of the pyramid. 

Autonomy : Autonomy in this context simply refers to having control over one's time. This is a need that is achieved by attaining financial independence. This requires the individual to build sufficient money for all of their family's financial goals. This would allow the individual to use their time as they please. Attaining financial independence is a significant challenge. It therefore offers a significantly higher degree of satisfaction compared to the needs met in levels 1 and 2.

Security : Security in this context means not having to worry about the availability of money at present or in the future. This includes leaving a reasonable inheritance for the next generation. Security is a natural consequence of achieving autonomy. It provides the greatest degree of lasting satisfaction. It therefore forms the top of the pyramid. 

There are a couple of interesting insights to consider here. Notice the relationship between the achievement of needs and lasting satisfaction. The more challenging the need, the greater the degree of lasting satisfaction derived. Most individuals predominantly focus on meeting needs in the bottom two layers. But it is those in the top two layers that offer the most satisfaction. 

The degree of satisfaction each individual would derive from meeting each of these needs may differ. But the necessity to meet each of them would remain universal. The same can be said for the degree of satisfaction derived from meeting needs in the upper two layers. It would therefore be prudent for individuals to prioritise meeting needs in the upper two layers over those in the lower two. In fact, taking care of the upper layers would naturally mean that the lower layers are also taken care of. 

Ignoring The Qualitative Aspects Of Financial Decisions 

Every financial decision has quantitative and qualitative aspects. Quantitative aspects are those that can be measured reliably using numbers and metrics. Qualitative aspects are more abstract in nature. They are related to behavioural and psychological traits of the individual. They are therefore subjective and hard to quantify reliably. But they have a material impact on the effectiveness of financial decisions. Let us understand this with an example. 

Take the case of a 30 year old individual. They have a secure job and are able to save 50% of their take home income each month. Their emergency fund is worth one year of their current living expenses. They are comfortably able to meet the monthly investment amounts for all their goals. They have no dependents and wish to retire at 55 years of age. They have no previous experience dealing with market linked investments. They have a tendency to overthink decisions. They tend to deeply regret unfavourable outcomes. They wish to allocate 70% of their retirement portfolio to equity, specifically mid and small cap stocks. 

In this case, the quantitatives (age, monthly savings rate, quantum of the emergency fund, capacity to save enough for all goals and investment horizon of 25 years) largely justify operating with a 70% allocation to mid and small cap stocks. But the qualitatives reveal a different story. The individual has no previous experience dealing with market linked investments. Introducing them to mid and small caps directly is very likely to be a step too far. This is even more true given the fact that the intended allocation is 70%. 

The individual also deeply regrets unfavourable outcomes. The individual is therefore psychologically ill equipped to handle volatility and permanent losses of capital. These two risks are inherent to investing in mid and small cap stocks. Both these factors imply that the individual may not be able to handle a 70% allocation to mid and small cap stocks. So they would be better off starting with a lower equity allocation (say 50-60%) to lower risk options such as Nifty 50 and Nifty Next 50 index funds. As the individual gains experience over the years, mid and small cap stocks may be considered. This can be done provided they learn to control and/or overcome their tendency to regret unfavorable outcomes. 

We usually implement a plan the moment the quantitative factors fall into place. Quantitative factors can make a financial plan look viable on paper. But it is the qualitative factors that matter more in the real world. They define how comfortable an individual would be with sticking to the plan. A financial plan is only as good as the individual's ability to stick with it over long periods of time. And the more comfortable one is with their plan, the more likely they are to stick to it. Both quantitative and qualitative factors therefore deserve equal importance when designing and implementing a plan. I would even say that the qualitatives deserve more importance than the quantitatives. 

Summing Up

Each of these three blind spots are typically too subtle to notice in the beginning. But over a period of time they get hardwired into our behaviour with money. And by such time, it typically becomes very hard to change our behaviour. The sooner we become aware of these blind spots, the earlier we are likely to address them. And doing this would only better our financial plans and investment behaviour.