What Behavioral Finance Can Teach Us About Making Better Financial Decisions
We know that emotions play a role in making financial decisions. As much as we’d like to think that personal finance is as easy as “spend less than you earn and save the rest,” there’s a whole lot of nuance that goes along with it, and it’ll vary from person to person depending on their behavior tendencies.
Psychology studies the human mind and its functions, particularly behavioral tendencies. The finance and psychology combination is an emerging niche in the financial service sector, and you’ll commonly find it referred to as behavioral finance. Financial planners can incorporate elements of psychology and finance into their risk analysis of their clients and use screening tools to help them better serve their clients’ financial needs. Others will incorporate financial counseling to help individuals with financial habits, leading to better financial habits and lives.
Let’s dig a little deeper into what behavioral finance looks like for the Muslim investor.
What is behavioral finance, and why is it important?
According to an article published by Business Insider, “Behavioral finance is a field of study that tries to identify and explain biases that cause people to make irrational investment decisions or behave in financially detrimental ways.” Historically, these concepts were used to explain investors' decisions on a macro-economic level. However, our biases affect our day-to-day actions and personal finances as well.
We are influenced by an excessive amount of information from social media, news outlets, peers, and the list goes on. Not being able to process the information adequately or not being aware of how it’ll affect us can lead us to be reactive instead of proactive, thus causing detriment to our personal finances, i.e., being our own worst enemy. Understanding our biases and tendencies will allow us to take a moment, pause, and make meaningful financial decisions that will set us up for success, insh’Allah.
Learned behaviors and biases
Our biases towards situations can harm or help us. Negative cognitive biases towards our personal finances can be detrimental to us. They may be the reason we’re feeling “stuck” or are never able to get ahead.
A negative bias is our brain’s way of reacting more strongly to negative interactions or situations as a protective measure. It’s how our brain keeps us out of harm’s way and ensures that we respond more strongly to protect you from that decision again in the future. Where this may harm us is the potential benefits that we may lose out on by reacting to a previous outcome. This type of behavior typically happens with individuals who may be more risk-averse.
Let’s explore some examples of negative biases that we might run into when making financial decisions. We’ll introduce the term “status quo bias,” which explains feeling resistant to change while knowing that staying in your current position at work is “easier” than starting over new, thus limiting you in your earning potential. Another example related to a negative bias is the “sunk cost fallacy” in which you decide to stay in a specific role or career knowing that it is not advancing you personally, professionally, or financially because you committed to that degree when you went to university, i.e., you already “paid” for it, so you might as well get what you “paid” for.
Another important concept as it relates to behavior finance includes learned behaviors. This is where your “money story” comes into play. Essentially, the experiences throughout our childhoods leading up to our adult lives become foundations for how we understand our finances and the financial world around us. This can be exposed to either the success or failures of entrepreneurship through a family member developing a learned behavior surrounding businesses. Or knowing that as a household growing up, your family also did X when it came to finances, either talked about it or didn’t talk about it, and as a result, this is a learned behavior that you now carry on into your home. These behaviors are not set in stone, but they influence how you approach financial decisions, including investing and saving.
How we make decisions are influenced by our cognitive biases and learned behaviors, sure, but what about when our brain is met with resistance or pressure to make a decision? Decision fatigue can be defined as losing the ability to make a decision that aligns with your values and needs. It occurs because we are met with many choices that involve making decisions throughout the day. So when it comes time to say yes or no to something that may or may not derail your spending plan or long-term financial goals, we have to be mindful of the fact that decision fatigue may be happening. One way to avoid this can be by giving yourself a rule anytime a money decision comes up that may be a big deal, i.e., any transaction over $100 will need to be written down for at least seven days before you decide to purchase. This can safeguard you from making decisions on impulse.
These concepts are just skimming the surface. If you’re interested in learning more about how emotions and psychology relate to finances, here are a few books that focus on this topic:
- The Mindful Millionaire: Overcome Scarcity, Experience True Prosperity and Create the Life you Really Want by Leisa Peterson
- Happy Money: The Science of Smarter Spending by Elizabeth Dunn and Michael Norton
- Money is Emotional: Prevent Your Heart From Hijacking Your Wallet by Christine Luken
How behavior translates into our daily financial transactions
So, we recognize that some of the above apply, and there is a good chance you can identify exactly which types of biases and learned behaviors you hold. Let’s now try to picture how some of this may play out in your everyday activities.
You’re at the grocery store, and you walk through the automatic doors and start to take in all the signs, colors, and sale items that are demanding your attention. You don’t have a list because you are coming in to pick up a few things for the next few meals and kids’ lunches. You’ll do your larger grocery shop this weekend, but you feel confident because you have a good handle on what you need. Marketing experts use psychology for product and ad placement to distract you, making you forget why you came to the store in the first place. Going grocery shopping is hard enough with a list and being alone; imagine what this is like without a list and with kids in tow. Marketing gurus will be choosing what to put in your cart for you. Now, let’s revisit those concepts we briefly discussed above; you are now shopping on impulse. Each item you look at and contemplate purchasing for an upcoming meal in your household is another hit to your brain’s ability to choose. Decision fatigue kicks in, leaving you with zero to little willpower. You are now vulnerable when making financial decisions that ultimately harm your personal finances.
This is by no means meant to shame anyone, I am guilty of this just as much as anyone else, but the goal is to bring awareness to everyday interactions with our finances that can affect our long-term goals.
I am also not here to tell you you can’t have something that caught your eye in the grocery store and wasn’t on your shopping list. I discussed goal setting and being on the same page as your partner in my previous blog post. Your spending should reflect those goals and plans you set together or your goals for yourself. If that means you’ve made it a priority to treat yourself to certain items because it’s important to you, then that’s okay. The most important thing is that your spending matches your goals, and you set safeguards against things that can derail your plans.
The key to getting ahead: awareness
We all have behavioral tendencies when it comes to our personal finances, but we won’t be able to harness change if we can’t identify what we do the most.
Knowing how you perceive thoughts surrounding finances and decision-making will be vital in making that first step to change. You’ll become more confident even if you aren’t able to reverse years of conditioning just yet, and awareness is the first step.
Routines that we can take from the sunnah of Prophet Muhammad
Good financial habits stem from good habits in general. Who else better to take notes from than from our own beloved Prophet Muhammad (peace be upon him)?
An excellent post written by Mohamed Faris of The Productive Muslim outlines The Daily Routine of the Most Influential Man in History, Prophet Muhammad (peace be upon him), in which he describes, “He begins his day with gratitude, recognizing what a gift it is to be alive for another day and reminding himself (and us) that there’s life after death which gives him drive and purpose to live the best version of himself that day.”
Here are some simple yet meaningful things we can do to emulate our Prophet (peace be upon him) and create good habits.
- He woke up early
- He was mindful and present within the first few moments of waking up.
- He was present with every step he took, providing purpose in his everyday activities.
- He put Allah (SWT) first in his morning routine, ensuring that prayer was prioritized.
- He engaged in meaningful relationships.
- He was easygoing.
- He had dedicated “working” hours, creating boundaries.
- He gave time to his family and was dedicated to nurturing these relationships.
- He slept early and would get up for night prayers to worship His creator solely.
When we take the time to develop good habits and undergo personal development using examples from the Sunnah, we will start to see positive impacts in every aspect of our lives simply from the extra barakah (blessings).
4 steps to changing the way we make financial decisions
So far, we have touched on psychology and how it can play a role in our day-to-day financial decisions, why awareness will be key in reversing negative cognitive biases, and how we can take examples from the life of our Prophet (peace be upon him) to develop good habits. But how can we put this into action?
Here's a step-by-step guide to reversing those negative personal finance behaviors.
- Identify the behavior (i.e., considering buying a commodity because your friends/family/community all have “it” and recognizing that this purchase doesn’t align with your goals)
- Set your intention. You recognized the thought pattern that developed, and you are now changing your mindset and setting your intention away from that purchase or re-evaluating if this purchase might align with your goals.
- Make small, actionable steps towards the expected outcome. Not purchasing it, but instead putting it on a wish list or setting an extra line item in your budget to allow for this purchase and putting money towards it within a specific timeframe.
- Put trust in Allah (SWT) and his plan. What happens was meant to be and ultimately may not be what we wanted but what’s best for us.
From daily interactions to your long-term investment strategy, knowing your behavioral tendencies can give you an advantage and prevent impulsive and illogical decisions that may ultimately be detrimental to your personal finances. Setting your intention, allowing an appropriate amount of time to pass, and putting your trust in Allah’s plan will ultimately make us all successful in this life and the hereafter.
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