BY: BYRON MOORE, CFP®
posted March 19, 2018
Question: I have seen my own parents and some of my friends do some things financially and otherwise that just seem obviously dumb. Or at least shortsighted. The example I’m thinking of when they buy things with a credit card that will then charge them 18% for the privilege. But it could be any number of things. Why do you think people make these kinds foolish financial decisions?
Answer: Economists like to say people are rational.
Whenever I read that, I think, “Sure are…sometimes. But other times, they are fearful, other times resentful, other times prideful and once in a while, just plain dumb.”
I know this from personal experience…with myself.
Like interest, financial decisions tend to compound over time – for better or for worse. So the level of thinking employed in making any financial decision tends to have ripple effects that impact us for years into the future.
There are four levels of thinking that I see employed in financial decision making. At various times, we all operate at all four levels, but just by identifying the levels, you’ll know where you want to be when making your most important financial decisions.
No thinking. Most of us make most of our financial decisions at this level. And (shocker!) this is a good thing, not a bad one. When I get to the checkout counter at a store, I don’t carefully calculate the pros and cons of whether to use a credit card, debit card, cash or barter. I don’t think about it because I’ve already thought about it before and know what I do in those situations.
Most of life is lived at the no thinking level. If we didn’t live most of life in this fashion, we’d never get anything done.
So, hopefully, prior thinking has developed good habits so that in the moment this kind of “no thinking” can actually be useful and efficient, rather than harmful.
On the other hand, too often we don’t decide so much as we react. We make “no thinking” decisions to seek pleasure, avoid discomfort, relieve pain or express anger, employing no forethought as to the future consequences. Lots of present and future pain is caused by this kind of “no thinking” decision making.
Simple thinking. Sometimes we think we are making better financial decisions by actually thinking about them…in isolation. So we see an item that normally sells for $10 that is “on sale” for $8 and we think “$8 is less than $10. Good deal! I’ll buy it!”
Or an automobile dealer offers to finance the purchase of a new vehicle for us. “0% financing!” the sign says. So we assume that’s a good deal.
Complex thinking usually requires that we slow down the decision making process to evaluate at a level deeper. In the car example above, the offer of 0% financing may not be the only factor in play. Suppose there is a “cash price” that is less?
For example, a car might sell for $30,000 financed over 60 months at 0%. So the payments are $30,000/60 or $500 per month. What if, however, the dealer would have sold you the same car for $25,000 if you’d paid cash? That means the true cost of the $500 payment you’re making on the “0%” deal is closer to 7.5%.
Complex thinking requires looking beneath the surface issues and dealing with more than one factor.
Holistic thinking. For big, costly financial decisions to be most effective, we need to employ holistic thinking. Financially-holistic thinking is similar to thinking about your physical health.
One the one hand, your physical health is the sum total of all the health decisions you have made up to this point – your diet, your exercise, your sleep habits, your living conditions, how you handle stress, etc.
In the car example, good holistic thinking asks, “Do I need a new car?” and if so, “how much can I afford?” These questions are asked before I start the car shopping process.
But not all decisions are equal. We may have great health habits and choose…just this once…to drink too much, then drive. Obviously, the result of a single bad decision (financial or otherwise) can be disastrous.
Why your parents or friends have made the financial decisions they have up to this point is complicated…and probably unknowable.
The lesson for you to learn is to employ the right kind of thinking – sometimes the “auto-pilot” decisions that come from good prior thinking; other times the careful, methodical holistic thinking required for significant, consequential financial decisions.
Don’t react…think.
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