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The way you think and are prone to behave will have a huge impact on the success of your financial decisions, according to behavioural finance experts. But not necessarily in the ways you might expect.
Being smart, for instance, doesn’t guarantee you’ll be good with money. Self-control is more important.
One marshmallow now, or two in the future: which would you choose?
In the late 1960s, Walter Mischel, an American behavioural psychologist sat a group of 4-year old children, one at a time, on their own in a room, with a marshmallow on the table in front of them. The children were told that if they did not eat the marshmallow, they would receive another marshmallow in 15 minutes and would be able to eat them both. But if they ate the first, they would not get the second.
Some children just gobbled up the marshmallow, others waited as long as they could and caved in, but some managed to resist the temptation and held out for the greater prize.
Observing the same individuals as adults later on, Mischel noted that those who were able to wait for two marshmallows when they were 4-years old had become more successful adults (success as measured by the usual yardsticks of academic achievement, careers, wealth, etc.). The ones who ate the marshmallow were more likely to have been less academic, taken drugs or gone to prison. He concluded that the stronger self-control of the two-marshmallow children had contributed to their success.
The lesson for our money is not quite as simple as “just be patient”. It is that self-control yields greater rewards in the future. So people who save their money for a rainy day will ultimately have more of it than people who spend it today.
This sounds obvious, but many of us still don’t do it. The trick is to try to “delay gratification” with each financial decision you have to make. So whether that’s choosing to pay for a new car now or to stick with the old banger for another few years; book the Disneyland holiday for next year instead of in three years’ time or stretch yourself to afford a bigger house now, even though that means going without a few luxuries, rather than waiting another 5 years to move.
Ps. The experiment did not conclude that the self-control exhibited by the 4-year olds was genetic. Good news for those who think they lack willpower now.
Are you a sheep or a salmon?
Do you like following the herd, or going against the tide? There is a lot of evidence that the up-river swimmers in the investment pack - “contrarian” investors, tend to do better than those who have a herd mentality and go along with their peers. Warren Buffett is a famous contrarian. But sometimes, the herd is right and it would be crazy to go against the tide.
Being a contrarian investor is not easy and depends a lot upon good timing - of both the purchase and the sale of the investment. Investment trends can come and go over night. You might think you are being contrarian, but then if everyone else is being contrarian in the same way at the same time, then you have inadvertently become part of the herd.
Whether you are a money pioneer or tend to go with the consensus affects more than just investing. When you choose savings or bank accounts, those that follow the herd would be more likely to stick with large, well-known brands, while contrarians might consider alternatives, such as peer-to-peer lending, or challenger brands. However, people using peer-to-peer lending do not have the same levels of protection if something goes wrong. Unlike bank accounts they can lose their money as FSCS does not protect them. P2P investors will only receive FSCS cover if the investment goes wrong after they were given bad advice to invest in P2P, not if the investment goes wrong after they made their own decision to invest.
Is your glass half full or half empty?
Well, for a lot of us, it is half empty. Psychological evidence suggests that most people feel the pain of a loss about twice as much as they feel pleasure from a gain of the same size. This fundamental tendency to experience more negative sentiment than positive leads to “loss aversion” with our money.
There is nothing wrong with innate pessimism when handling your hard-earned cash; caution can help you protect your assets and grow them steadily rather than risk extreme losses. However it can have the result that an investor takes on less risk than is appropriate because he or she tries to avoid losses to any single part of their portfolio, rather than focusing on how it is performing as a whole.
Ford Focus or... Bugatti?
Do you prefer a safe, steady journey or a fast ride, with lots of twists and turns? Risk averse individuals are more likely to choose cash savings accounts and government bonds, accepting the lower return in favour of peace of mind that they should not lose their original capital. Risk takers on the other hand enjoy the thrill of chasing higher returns and although when they win, they are likely to win big, they also must accept the prospect of losing all of their money.
In a report called Behavioural Finance, The Psychology of Financial Decision Making, Greg Davies, head of behavioural analytics at Barclays Wealth, says: “Which would you regret more – having missed the opportunity to buy a stock, which went up by 45%, or having sold the same stock before it went up? People who don’t usually take risks fear errors of commission, i.e. mistakes because of their actions. Conversely, individuals who have experience taking risks worry more about errors of omission, i.e. having the chance to make a good investment and missing it.
The thing to remember is that both have the same impact, so there isn’t much point in regretting either. “It is important to recognise that they have the same effect upon our wealth, and we should keep a broad perspective on such decisions,” says Mr Davies.
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Money Means is a news and information series written by independent financial and consumer journalists and experts. FSCS launched Money Means in 2016 to help give people clear and useful information about personal finance, to increase their understanding and confidence when dealing with money.