Why We Make Bad Financial Decisions – And What To Do About It

One of the key reasons I started Banker On Fire is to help people make better financial decisions.  I get very, very frustrated when I see family members, friends and colleagues make choices that end up costing them thousands or tens of thousands of pounds over the long run.  Atter all, money equals freedom, and making the wrong choices when it comes to money means you end up missing out on the kind of life you want. 

So why is it that we make bad financial decisions?  And more importantly, what can we do to make better ones? 

Why We Make Bad Financial Decisions

1.  Lack of (financial) education

In my opinion the #1 reason people make poor financial decisions is because they simply have NO IDEA.  Can you imagine a doctor who doesn’t understand medicine or a lawyer who doesn’t know first thing about law?  Neither can I.  So why is it that so many people expect to build wealth if they don’t understand the very basics of finance? 

If you are truly serious about building wealth, you should have a perfect understanding of basic concepts like time value of money, compound interest and rates of return. 

You should understand the relationship between risk and return and the difference between debt and equity.  And you should definitely understand the basics of taxation and the difference tax-efficient investing can  make over the long run.  If you don’t, you will only grow your wealth if you get incredibly lucky

Solution:  While personal finance is now increasingly being taught in schools, it is still far from ubiquitous.  If you missed the boat as a student, don’t despair.  There is an absolutely massive amount of free, quality information on investing online. 

At some point I will do a summary of good financial education resources on the web.  In the meantime, I suggest you google the concepts above and read at least the top 3 results for each term.  If you don’t understand something, feel free to post a question in the comments section below and I will be happy to help you out.   

2.  No time and energy

You rush from the office to pick up your child from nursery.  You cook dinner, give him a bath and read a bedtime story.  Then you have a bite to eat yourself before cracking open your work laptop to catch up on your emails and finish up that urgent project. 

By the time midnight rolls around, are you really going to be thinking about reinvesting your dividends or choosing between a pension and a LISA? And are you really going to be motivated to work on that side hustle? 

I am always amazed that there are so many smart, educated, hard working people out there who prioritize their employers’ well-being over their own.  Yes, you need to do a good job at work, but at the end of the day, would you rather build wealth for your employer or yourself? 

Solution: Ruthlessly prioritize your own objectives.  Do enough to be well-rated at work and get that next promotion.  At the same time, remember that if you let your day job occupy all of your free time, it will.  Don’t fall into this trap. 

Treat your personal finances as a business.  Set aside 10-15 hours a week to optimize your investments, make new ones or start a business.  Be accountable to yourself the same way you are to your boss. 

3.  Misalignment With Family

In the proverbial boat of life, everyone needs to row in the same direction if you want to end up in the right place.  If for whatever reason your significant other can’t pick up an oar, they least they can do is stay out of your way. 

If they don’t, there is a very high likelihood that you will not achieve the goals you set for yourself while suffering from marital discord. If you are a saver and your husband is a spender (or vice versa), it is only a matter of time before matters will come to a head. 

Solution: communicate and compromise.  Clearly state what your personal and financial goals are and get your wife or husband to do the same.  Share your respective ideas of your best life and get your significant other to explicitly support you. 

Building wealth is a long and challenging exercise.  Make sure you have the support of your loved ones as you embark upon it. If you haven’t yet got a partner, make sure to find one who is fully aligned with your goals and objectives.  If you already have one, do the best you can to make sure both of you are aligned and marching to the same beat. 

4.  Imperfect Information

This is a pervasive problem that manifests itself in many ways.  We don’t know how much money we have and where it goes.  We don’t know the relative performance of various investments.  We don’t even know how long we will live!  How can we estimate how much money we need to save up?

Solution:  Thankfully most of the information we need to make good financial decisions exists, so you just need to get on with finding it.  It is only up to you to start tracking your income, spending and net worth

Unless you happen to be investing in very exotic asset classes (and there is no reason you should), you will be able to find historical performance data online.  And yes, there are tools that allow you to estimate your life expectancy (mine is 82 apparently). 

As with anything forward-looking there will always be an element of uncertainty.  If you let it paralyze you, you will never get anywhere.  Instead, focus on long-term trends that have held true for hundreds of years and will continue holding true going forward.  Stocks will generate a higher return than cash.  Real estate will grow slighly ahead of inflation.  And using leverage responsibly will juice your returns

5.  No Self Control / Instant Gratification

A few hundred years of modern civilization have not yet offset millions of years of evolution.  As a result, in many respects our brains are still wired in primeval ways. 

Our desire for instant gratification is a perfect example.  Thousands of years ago, survival was all about securing your next meal, finding shelter for the night and identifying a partner to mate with.  Because of the realities of life back then, planning far ahead was not on the agenda.  No wonder why people have a hard time saving for retirement or putting aside money to invest!

Solution: thankfully, self control is a personality trait you can develop and sharpen.  To make things even better, delayed gratification is often more enjoyable that instantly rewarding yourself.  After all, we are at our happiest when we are on our journey towards a goal, as opposed to once we have achieved it. 

The best way to build your self control is to start small, and it doesn’t have to do anything with your finances.  Force yourself to be in bed by a specific time every night.  Have an apple instead of a cookie every afternoon.  Go to the gym twice a week.  Then reward yourself once you’ve hit your objective.  You’ll be surprised how much better you feel – physically and mentally. 

Conclusion

In order to start making good financial decisions, you need to stop making bad ones.  At times, all of us fall into the trap of making some of the mistakes listed above.  The ones who end up being successful are the ones who can take an honest look in the mirror, identify the mistakes we make and put a plan in place to make sure we don’t repeat them. 

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