Introduction to Psych Yourself Rich: Get the Mindset and Discipline You Need to Build Your Financial Life
- Aug 17, 2010
Being decisive about money can be a crapshoot. By the time you finish reading this book, you'll find out why and what you can do about it.
Ask yourself: Why is it that even the best, most coherent, and logical financial advice does little to mobilize us into thinking about or taking control of our money in a meaningful way? Rarely does a lecture on retirement savings and life insurance inspire us to build a path toward improved security and financial well-being. When it comes to making decisive financial choices, there's a visible disconnect between our mind and our actions.
Between earning money and spending lies a world of uncertainty—a gray area. We lose sleep over finding the right answers to questions such as: How much should I really spend on a house? Maybe I should just rent? Do I put more money into stocks? Where is my money best invested? Why can't I kick the credit card habit? How do I budget for uncertain times? Why do I make impulsive purchases? What was I thinking when I bought this Vespa? And why do I feel the need to keep giving money to mooching friends? Why, when I know better?
- Do you see yourself up there in that swirl of hows, whys, and wheres?
Psych Yourself Rich is based on the principal that our financial lives—much like life in general—are powered and transformed by personal choices and behaviors, both of which are rooted in our values, perspectives, goals, and financial means. Rarely, though, do we really consider all of these key variables when making a purchase, investing in stocks, building savings, or charging against a credit card. Sometimes we just look at price tags and shrug in compliance, or perhaps we're so narrow-minded about our goals we miss great financial opportunities. In other cases, we can't even get to the point of making any decisions. We feel paralyzed and stop dead in our tracks. Emotions prevent us from getting the right help. So instead, poor decisions are made, or worse, nothing at all is done.
A Behavioral Bubble
Emotions play an enormous role when managing personal finances. Many behavioral experts will go so far as to say that our emotions can potentially destroy the ability to make sound financial moves. The most recent recession is one such example of bad financial decision making. Finance and economic experts, including Curtis Faith and Dan Ariely (both best-selling authors), have told me that human behavior played a great role in the financial crisis that began in 2008 and continues to this day. Many were caught in a "behavioral bubble"—thinking and acting irrationally, expecting that home prices would rise generously year after year. This behavioral phenomenon was introduced in 2002 by Princeton University psychology professor Daniel Kahneman, who won the Nobel Memorial Prize in Economics for his work into how individuals approach uncertainty.1 Kahneman's research sheds new light on the theory that investors are prone to behave irrationally. His argument debunked the traditional economic theory that investors make rational and calculated decisions when the stakes are high, that they learn from their mistakes, and are able to adapt to changes over time.
Since the 1970s, a growing group of economists have explored this fringe viewpoint of irrational investing, but it was Kahneman who brought it to the forefront of modern finance and gave a whole new momentum to what we now popularly discuss as behavioral economics or behavioral finance.
Behavioral finance has struck a major chord within the financial community—so much so that the big investment firms have begun to help their risk-averse clients regain confidence in the markets with internal teams of behavioral finance experts—Barclays Wealth in Europe, to name one. As the bank sees it, different individuals have a predisposition to their own type of investing that makes them more comfortable with that approach over time (i.e., they do what feels emotionally good). Greg Davies, the head of Behavioral Analytics at Barclays Wealth, explains in a bank report that "Everyone sees the world from a perspective which is uniquely theirs, and investing is no different. People have individual goals, requirements, desires, fears and hopes for their wealth. We all have different habits, different people we trust for advice, and different beliefs about the right decision on any occasion."2
We're only human, right? Our emotions play a massive role in practically all facets of life...why not money management? The trouble is that emotions often restrict us from making sound financial decisions. Jay Ritter, the Cordell Professor of Finance at the University of Florida and an expert on behavioral finance, recently told me that he believes we are all afflicted by "cognitive biases." Translation: mental barriers. We lean toward following easy, but not always helpful, rules of thumb. Some individuals (especially men) are overconfident about their decision-making abilities, which can manifest in investing excessively and not asking for help when it's really needed. I found this to be true, while doing research in 2009 on the trading strengths of women. A study3 of 30,000 single male and female investors found that women's portfolios performed a slight 1.4% better than men's.
To learn why, I called Terrance Odean, coauthor of the study and the Rudd Family Foundation Professor of Finance at the Haas School of Business at the University of California, Berkeley. Odean told me that being too bold doesn't always pay off in the investment world. "We hypothesized men would trade more actively than women because of their greater overconfidence in trading ability...and this trading would hurt their returns. We were exactly right," he said. And not only are some of us too confident, we're sometimes too optimistic, a byproduct of human nature and an American culture that emphasize positive thinking.
According to Ritter, we tend to rely more on short-term patterns rather than long-term patterns, which can prove detrimental when making decisions that concern certain financial moves like investing in the stock market or buying real estate. "People tend to put too much weight on recent experiences," says Ritter. Just think about the latest housing bubble and how many of us were convinced real estate prices would never slow down. In addition to recency bias, another behavioral tendency that plagues us is "group think." For example, many individuals believed—and were told by experts—that high returns were normal and should continue. Humans are prone to trusting conventional wisdom, the actions of crowds, and staying on the beaten path.
Ritter, who also teaches a course on financial decision making, says another reason it's often hard for individuals to make money decisions is because they're not trained to think about things like mortgages, car loans, and investments on a daily basis. These topics are largely foreign until we are forced to deal with them. But what about spending, I asked? We certainly do that on a day-to-day basis, but still many times without really thinking about the consequences. "That's a matter of people putting more weight on current gratification versus thinking about the future." As humans, we emotionally prefer to live in the now and deal with tomorrow when it arrives. This explains well my irrational Vespa purchase in 2006. (Don't worry, Mom. I returned it.)
One study that really surprised me was a 2005 report published in the Journal of Psychological Science. Researchers from Carnegie Mellon University, the Stanford Graduate School of Business, and the University of Iowa discovered that brain-damaged people with an inability to experience emotions made better financial choices. After completing a basic investment game that required math and logic, the mentally impaired individuals actually ended up with 43% more money than the mentally healthier participants. The conclusion: If you just stick to the facts and figures and take the emotion out of it, you'll have a better potential to make money.
But, of course, that was just a game. Interestingly, the study also discovered that while the brain-damaged were better at this one game, the healthier participants were better at dealing with day-to-day financial issues. So, emotions can come in handy. Intuition can be an important weapon in making healthy financial choices. As Ritter tells me, having a fishy feeling or thinking something is too good to be true is an example of tapping into your emotions. "You may just call that being skeptical, too," he says. And those intuitions can sometimes keep your money out of trouble.
- To achieve the things you want, you need to understand your relationship with money, your belief system, and why you act the way you do.
The goal of Psych Yourself Rich is to help you become accountable for your financial decisions and to manage the behaviors that either bring you closer to or distract you from reaching your life goals.
That's the notion behind the title of this book. To "psych" yourself rich means to develop the brainpower—the mental discipline and positive behaviors—you need to traverse volatile times, build wealth, and secure your financial well-being.