Your Brain Makes Building Wealth Hard

One of the first steps to overcoming a challenge is to recognize there is a problem. If you do not know where your stumbling blocks lie it is often impossible to achieve the results you desire. In the wealth building process there are multiple challenges, but one that many people don't recognize is your own brain. Our brains developed to do a great job helping us hunt, gather, and reproduce. Unfortunately our brains are not particularly suited to the challenges of creating wealth.

There is [relatively speaking] a new field of study called Behavioral Finance. The basic idea is that investing decisions are made by people, and people are influenced by psychology in addition to the pure numbers of the markets. In fact, investors (being human) are subject to quarks of neurology, biochemistry, and evolutionary anthropology which in turn influence all of our money decisions.

So, now that we realize that there is more to investing than just the numbers, what does that mean? First off, it means that your brain is not always aligned with your aspiration to build wealth. In many cases your brain can drive you to do the wrong thing with staggering regularity. The best example is the tendency to sell your investments (in panic) during a market downturn.

Everyone knows that to make money a person must "buy low, sell high" but in practice most investors jump on the bandwagon when the market seems to go up, up, up and then sell to stop the pain as the market falls. What is the result? The average investor buys stocks when they have already gone way up and sells after they have dropped. This is a "sell low, buy high" strategy that will loose money every time. Why then do some many people follow this pattern?

The short answer is people "feel" the pain of a loss in the market much more strongly than they "feel" the joy of a gain in the market. Think about this, if you have saved a nest egg of $200,000 which would effect your emotions more, gaining $20,000 or loosing $20,000. The vast majority of people are more emotionally impacted by the loss. In order to stop the pain, they sell the stock. This effect is call Myopic Loss Aversion and has been studied and documented in the majority of people, professionals and amateurs alike.

Behavioral finance relates to several other important ways in which your brain sabotages your finances. It has uncovered important data about why people have such a difficult time saving, budgeting, and investing for the long term. It turns out we are nearly all subject to a Stone Age era inability to evaluate the benefits of long term returns versus instant gratification.

Centuries ago it was much better to have a bird in hand (to eat tonight) than to wait a few weeks or months to be able to eat two birds. If you starved now, doubling your "investment" isn't worth anything (you'd be dead). This is one key reason our instincts fail us when it comes to evaluating market returns. Market bubbles and crashes are another example of psychology creeping into our investing reasoning (and reaping havoc).

In other words, behavioral finance has some impact on nearly all aspects of our financial lives. Now that we know there is a problem, lets do what we can to create wealth for ourselves in spite of our brain.