Everyone has to make big decisions about money, even if we don’t really like it. It’s a tough job and usually requires a lot of thought. Letting a TV show on Netflix run over to the next episode is so much easier. All it takes is five seconds and the next one starts.
But at some point, we have to turn it off, be grown-ups and think about the future.
Money is an obvious topic for thought when it comes to future plans. “How much money do I want to be making in five years?” “Do I want to buy a house?” “How much should I be saving?” “Should I invest in a home cinema with projector screen?”
Rather than deciding these things on impulse, it’s best to sit down and think about what you want and how to achieve it, because any decision will have consequences. If you definitely want to buy a house, but move into a rental that’s shooting way above your target, then, as a consequence, maybe you won’t be able to buy.
Unfortunately, people aren’t great at predicting consequences, either positive or negative, and immediate rewards can be more tempting. This often leads people to make “bad” money decisions.
The point, however, isn’t to stop us from ever making “bad” decisions – it can be fun to be bad every now and again – but to be more aware of why you made that decision and what the consequences will be.
The rational vs the intuitive brain
In 2011, psychologist Daniel Kahneman published a book called “Thinking, Fast and Slow”. You may have read references to the book in a few other eZonomics articles.
Kahneman posited two modes of thought: a “System 1” that thinks intuitively and is more reactive, and a “System 2” that works through things more carefully, using logic and reason.
When it comes to long-term financial planning, it can be best to let System 2 do the thinking. It is much better at analysing your financial situation, weighing pros and cons and coming up with different future scenarios that depend on your money choices.
However, there are some hurdles to making good financial decisions, even with the rational part of your brain.
What you know you don’t know
First, you can’t make decisions based on information you simply don’t have. Lack of knowledge about money management or finance in general plays a big role in many financial “mistakes” that people make.
For instance, if you want to get a loan but aren’t aware of compound interest, you might be surprised by the amount you’ll be paying back.
As a result, it’s easy to get overwhelmed by the complexity of financial considerations and end up procrastinating or not doing anything at all. But if you keep putting off opening that savings account, you’re also putting off increasing your funds over time.
It’s important to note here that the lack of knowledge is not your fault. Most schools don’t teach money management, at least not as a default option. So people often have to rely on their parents and eventually on themselves to learn.
Luckily, the internet is making things a bit easier by providing online resources (like us!) where you can read up on financial topics to educate yourself.
Take charge to get ahead
Another key factor for good long-term financial planning is self-regulation. This means taking charge of your thoughts and behaviour and not getting swept away by impulse buying, even when marketers are very good at their job.
It can be quite difficult, though. For one, people tend to prefer short term, immediate rewards over rewards that will be reaped in the long run, even if those rewards will be higher.
This is due to what is called temporal discounting, which means that the further away in time a reward is, the less valuable it becomes to us. This is mainly because we struggle to predict or imagine a realistic vision of our future and to picture future benefits.
This means that we are more likely to spend now than save that money for something we need in the future.
An economist’s perspective
As you can see, long-term financial planning is hard and there are many elements of human behaviour at play. The challenge is not to get rid of those behaviours, because most of them are just part of being human, but to be aware of them so we’re better prepared to keep our impulses in check when necessary.
We asked Steven Trypsteen, an economist at ING in Belgium, to tell us about his big money decisions with long-term consequences and how he handled them.
He gave us two examples: renovating a house he had bought with his partner and starting a family.
When it came to renovations, he looked mainly at things that would increase the value of the house itself, like roof insulation and double-glazed windows, even though those are very expensive.
They would also cut energy costs, bringing savings in the long-term and be environmentally friendly. So Steven decided to spend a bit more, thinking about these future gains.
Decisions around starting a family were a bit trickier. When buying things for the baby, Steven, like many (future) parents, was tempted to go with more expensive items that were assumed to be “safer”. Rationally, he realised that this is not always the case, but emotionally it was a tough call.
So no matter how much we know about money and finance, there will always be hurdles in the way of making “good” long-term financial decisions. All we can really do is learn from our mistakes and be more aware of the hurdles so even if we don’t make a “good” decision, it’s at least an informed one.