By Satvik Agarwal
Abstract
People’s everyday financial habits like spending and saving, are impacted by a plethora of psychological factors which affect the financial stability and the economic well being. Frequently, people make economic decisions which aren’t in their best interests due to various social pressures, emotional pressures or just rooted habits which may lead to problems of extreme spending or no saving. Understanding these factors can lead to improvement in the way financial education programs are designed, which will be a helping hand to individual’s making better financial choices. However, improving financial literacy alone is inadequate; advanced financial education must embed an understanding of psychological influences behind spending and saving to better personal financial stability.
Literature Review
In the exploration of financial decision-making, studies have more and more highlighted the influence of psychology on individuals' saving and spending behaviours. Behavioural economists, Richard Thaler and Cass Sustein (2008), argue that financial decisions consist heavily of biases and emotions, this lead to the development of “nudge theory”. Nudge theory suggests that slightly altering the choices which are presented to people can have a significant impact on savings and spendings without restricting their freedom of choice.
Additionally, Ariely and Loewenstein (2006) indulges into the emotional aspects of personal monetary decisions. The study highlights the fact that emotions like anxiety, stress, excitement can lead to biassed judgement which may cause reckless decision making. For example,people experiencing high stress are more likely to engage in retail therapy, with approximately 62% of individuals admitting to impulsive purchases driven by stress.These studies indicate that financial literacy should just go beyond basic budgeting skills and should also teach people to recognize and manage these psychological aspects of their financial behaviour.
Additionally, a vital viewpoint of behavioural economics, introduced by Riis et al. (2005), examines the influence of emotions in financial choices. The research demonstrates how individuals’ moods and emotional conditions can significantly affect their spending and saving behaviours. For instance, positive feelings might promote riskier investments, whereas negative feelings, such as fear, could lead to excessively cautious financial choices. Identifying these emotional triggers in financial education initiatives can motivate individuals to make more rational choices and lessen the influence of emotional fluctuations on their financial well-being.
Role of Cognitive Biases in Financial Decision Making
One of the most significant cognitive biases which affects personal finance is called present bias. This occurs when one tends to focus on short term gratification and satisfaction over long term goals like retirement. Many behavioural economists believe that the problem of present bias can be solved through an automatic savings program or using reminders to help many save for their long term goals while not also feeling an instant dent in their income. Programs like “Save More Tomorrow” also help combat this bias.Thaler and Benartzi “Save More Tomorrow” program increased savings rates by an average of 15% over three years. This is done through slowly and gradually increasing the rate of savings of a user, this will lead to a reduction in the feeling of loss in the short run while still maintaining a better financial outcome for the future(Thaler and Benartzi, 2004).
Furthermore to present bias, loss aversion also plays a crucial role in that of personal economic decisions. Studies show that when people face losses they have a more significant impact than when they receive gains or profit (Kahneman,2011).This may lead to poor investments, such as holding onto stocks which are leading to loss or not investing in lucrative investments because of the fear of losses. Addressing this issue will involve making individuals understand the emotional impacts of losses and educating them to make more rational choices, like diversifying their investments or rebalancing their portfolios to minimise risks and take advantage of long term gains (Ariely and Loewenstein, 2006). By addressing all the cognitive biases, individuals will be in a better state to make logical choices which align with goals like home owning, car purchasing, retiring, etc. For instance, establishing automatic transfers to savings accounts can assist individuals in saving regularly, avoiding the necessity for deliberate choices every time. Moreover, comprehending the impact of loss aversion fosters a more diversified and balanced investment strategy, lessening risk aversion and enhancing growth (Thaler & Sunstein, 2008).
Social and Emotional Influences on Financial Behaviour
Besides cognitive biases, social and emotional influences also play a big role in an individual’s personal budgetary decisions. Social comparison often leads individuals to match the spending of family and friends, even though it may lead to future financial constraints. Research shows that nearly 40% of individuals report making purchases to keep up with their social circles.This phenomenon is known as “keeping up with the Joneses”. These desires to be on the same level as their social circle frequently leads to unnecessary purchases and distracts one from being aligned with their own financial timeline. These social pressures are often found in consumer-driven societies where material purchases equal to the social hierarchy level (Ariely and Loewenstein, 2006).
Moreover, emotional spending is also an aspect which commonly leads to impulsive purchases, in response to stress, boredom, or sadness. These habits are named as retail therapy. This may provide temporary relief and happiness but eventual regret and financial instability. For example, 50% of individuals acknowledge that shopping is used as a medium to improve their moods, or purchasing bizarre items when one is in a state of sadness or boredom(Riis,2005). By teaching emotional regulation strategies within financial education programs, individuals can learn to manage these impulses and make more intentional spending decisions that align with their long-term goals.
Tackling these emotional and social factors in financial education might involve resources such as budgeting apps that assist individuals in tracking spending habits, workshops emphasising goal-setting, or mindfulness strategies to encourage thoughtfulness in buying decisions. By employing these methods, people can cultivate resilience against outside influences and uphold a financial plan that emphasises their personal needs and objectives over short-term social or emotional rewards.
Conclusion
Comprehending and tackling the psychological and social factors affecting financial choices can result in enhanced financial stability and overall well-being. Cognitive biases like present bias and loss aversion, along with social and emotional influences, greatly affect financial behaviours, frequently hindering individuals’ long-term monetary objectives. By integrating knowledge from behavioural economics, such as Nudge Theory, into financial education, people can be steered towards making improved choices that correspond with their objectives. Financial literacy initiatives would gain from incorporating these behavioural insights, providing individuals with the resources to cultivate strong financial habits that align with their long-term goals.
References
Ariely, Dan, and George Loewenstein. “The Cold, Hard Truth about the Costs of Dishonesty.” Harvard Business Review, vol. 84, no. 9, 2006, pp. 23-26.
Kahneman, Daniel. Thinking, Fast and Slow. Farrar, Straus, and Giroux, 2011.
Riis, Jason, George Loewenstein, and Raja Ranganathan. “The Influence of Affect on Financial Decision-Making.” Psychological Science, vol. 16, no. 6, 2005, pp. 476-481.
Thaler, Richard H., and Shlomo Benartzi. “Save More Tomorrow™: Using Behavioral Economics to Increase Employee Saving.” Journal of Political Economy, vol. 112, no. 1, 2004, pp. S164–S187.
Thaler, Richard H., and Cass R. Sunstein. Nudge: Improving Decisions about Health, Wealth, and Happiness. Penguin, 2008.
