Last week, I read the latest book written by my good friend Rose Fres Fausto titled “Why Financial Education Alone Does Not Work.” According to her book, several studies show that financial education does little to improve people’s ability in making good financial decisions. In other words, teaching people about the laws of money, how to compute for interest rates, compounded growth rates and the different investment products that are available does little to help lift them out of poverty.
This reality is bothersome, especially for someone like me who believes in empowering Filipinos to become financially free by educating them about money.
According to Rose, financial education doesn’t work because people use emotions rather than logic in making decisions. This includes decisions on whether or not to spend, how much to save and invest and where to invest.
In her book, Rose discusses 16 emotional biases that jeopardize people’s ability to handle their finances wisely. To effectively educate people about money, they need to become aware of these biases and learn how to deal with them.
Out of the 16, here are some of the biases that I commonly see, and possible solutions on how to overcome or take advantage of them to stay on track with our investment goals.
Hyperbolic discounting
(present bias)
A lot of people don’t invest even if they know the importance of investing and the power of compounding. This is because the temptation to enjoy something right away is too hard to resist, especially when the potential rewards of delaying gratification is still several years away. After all, we can gain a lot of likes and be more popular by posting about our new purchases and cool experiences in social media. In contrast, we need to wait for a long time before we can enjoy the fruits of our investments.
One way to overcome the temptation to overspend and risk not having enough for investments is to automate the process. When I do talks for young adults, I always tell them to prioritize setting up a bank account that is separate from their payroll account. Every payday, they should automatically transfer 20 percent of their salary to the separate bank account and use the money in that account to buy investment products. That way, they will be less tempted to buy unnecessary things since they won’t have extra funds in their payroll account.
Default bias
Although there are so many seminars and free online resources on how to successfully invest in the stock market, not a lot of people own stocks. In fact, less than 2 percent of Filipinos own stocks. Surprisingly, even people working in the finance industry don’t invest in stocks. This is because to start investing, people need to go out of their way to open an account with a stockbroker. The process of deciding what stocks to buy and how much to buy can also be very daunting. In contrast, the default, which is keeping money in a savings account in a bank and occasionally placing extra money in time deposit, is much simpler, even if the returns are extremely low.
While there is no short cut to opening an account with a stockbroker, you can minimize the complications of investing in the stock market by just buying equity funds that are managed by professional fund managers instead of doing the stock picking yourself. You can also automate the process by allocating a certain amount of money toward the purchase of these equity funds every payday. Even with very little effort, these funds will grow overtime and you will be thankful for your decision to automate the process of buying equity funds every payday.
Pain of paying in cash vs credit card
When buying a product or service, it is usually more painful to pay with cash instead of credit card. When we pay in cash, we see the money in our wallet getting depleted, which is painful. In contrast, we don’t know how much we are spending when we pay using our credit cards, which makes it less painful. Unfortunately, because it is less painful, it is also easier to overspend.
To reduce the risk of overspending, we can take advantage of this emotional bias and pay with cash as much as possible. For those who want to minimize the use of cash because of the pandemic and would like to practice contactless payment, use mobile wallets which are now also widely accepted, instead of credit cards. While mobile wallets might not be as effective as cash, they also help minimize the risk of overspending by showing us how much money we have left every time we buy something. We are also forced to stop spending when there are no more funds. This makes it easier for us to stick to our budget compared to paying with credit cards.
Sunk cost fallacy
I know a lot of investors who own stocks that they regret buying but are not willing to sell. This is because they don’t want to cut their losses. After all, the stock that they bought is already a sunk cost. Maybe someday these stocks will rebound and can be sold at a profit.
However, these investors don’t realize that because they insist on holding on to these losing stocks, they will miss the opportunity to buy other stocks that have better prospects of going up. While there is a possibility that their losing stocks will rebound, there is also a possibility that they will stay depressed.
In deciding whether to keep a losing stock, ask yourself this question – “If I still don’t own this stock today, do I want to buy it?” If the answer is no, then you should sell your stock right away.
Although there are many other emotional biases that prevent us from reaching our investment goals, I hope that these four tips will be enough to encourage many of us to finally start our journey toward financial freedom.
If you would like to learn more about the other emotional biases, I highly recommend reading Rose Fausto’s book as she has a very fun way of talking about these emotional biases.