Your personal finance depends on your natural tendencies
Just like many other people who are not in the finance industry, I started learning about personal finance by reading. I read books, blogs, and news articles. I also learned a great deal from trial and error. Self-made mistakes sear lessons in my mind more permanently than lessons I passively consume.
I learned that it is not wise to merely imitate what we read.
Personal finance is just that: personal. A finance strategy that works splendidly for one person might be a horrible idea for the next. Applying cookie-cutter suggestions without understanding ourselves first is a recipe for disaster.
Our natural tendencies play a major role in influencing our personal finance decisions. When looking at tendencies, it is easy to fall into the trap of black and white labeling. For example, we say that we either risk-tolerant or risk-averse. But the truth is, tendencies are fluid spectrums and we are somewhere between two extremes.
When we understand our tendencies, we can either play them up or dial them down, depending on what the situation and our goals call for. If we are not aware of them, we will be at the whim of unconscious decision making, which may or may not serve us well.
Tendency #1: Risk tolerance vs. risk aversion
Our level of risk tolerance has a significant impact on our personal finance, particularly in the area of investing.
When we invest in something, we are risking an amount of money in hopes of getting more in the future. All types of investments have an inherent risk, some are riskier than others.
Depending on our risk tolerance and knowledge of financial instruments, we will tend to favor some types of investment over others.
If left unchecked, we might make bad decisions when our personality borders on one of the two extremes: being too risk-tolerant or too risk-averse.
If our risk tolerance is high, we might be inclined to invest in high-risk high-reward investment vehicles. The line between investing and gambling can be blurred rather quickly. Nowadays, it is dangerously easy to open accounts for trading high-risk products such as options or leveraged products.
On the other hand, being too risk-averse can negatively impact our personal finance as well. If we are too careful, we will miss out on investment opportunities. We will save all our money in cash. Due to inflation, the value of our cash savings will dwindle with time resulting in negative returns.
It is important to note that the risk of a particular investment depends very much on the competence and knowledge of the person with regard to that particular investment. In simpler terms: the more competent a person, the lower the risk.
If George Soros buys a few million USD of options using his knowledge of macroeconomics, it is probably a low-risk investment. Because I do not possess his knowledge or experience, the same investment would be merely a gamble to me. I would have better chances of making money at a high-stakes poker game.
High-risk investments can be volatile: their prices can fluctuate a great deal in a short timeframe. When choosing an investment, we have to consider our emotional tolerance for risk as well.
Even if we convinced that a certain high-risk investment will do well over time, our lives will be a nightmare if we are too anxious to ride the emotional roller coaster of price swings. Sometimes, it is wiser to choose a good night’s sleep over more money in the bank account.
When building our investment portfolio, there are no absolute answers of what is right or wrong. We have to decide for ourselves. Being aware of our level of personal risk-tolerance will increase our chances of making sound decisions.
Tendency #2: Instant gratification vs. delayed gratification
Our natural tendency to prefer instant gratification or delayed gratification will influence our spending habits, thus impacting our personal finance. Just like any other personality trait, going too much in one extreme direction or the other is never good.
If we focus instant gratification, we will spendthrifts. We would buy anything we want right now with no regards for the future. Obviously, if we spend every penny we have on a whim, there will be no chance to save up for a nest egg.
Regardless of how much we can earn, it is always possible to spend more than we earn. We have seen enough examples of bankrupt celebrities who have purchased exotic animals, renaissance paintings and private jets.
On the contrary, focusing merely on delayed gratification alone has disadvantages as well. I have seen people who are extremely stingy with the aim of saving up for retirement. They believe that when they retire, they can finally enjoy the fruits of their frugality. Here’s the kicker: when retirement finally comes, they are still stuck in the frugality mindset. Some of them suffer unnecessarily because of the self-imposed austerity.
Ideally, we find a happy medium between living in the present and preparing for the future. We should spend money to take care of our current wants and needs. At the same time, we should put aside enough money to save and invest for the future.
Many personal finance books and blogs tell us to save X amount of dollars or Y % of our monthly pay. This kind of absolute advice is moot.
The amount we should spend and save varies on our individual needs. We have to find our own balance, based on factors like:
- our current income
- our long-term financial goals
- our short-term needs and wants
For example, a person who earns $3 million a year who saves 10% of the income can reach the same financial goal faster than a person who earns $30k a year and saves 90% of the income.
Instead of parroting what we read and hear, we should listen to ourselves to strategize our own healthy balance between delayed and instant gratification.
Tendency #3: Flexibility vs. rigidity
Our investing habits are affected by how mentally flexible or rigid we are. If are mentally rigid, we tend to continue to persevere on our previously chosen path without wanting to change our habits, attitudes or belief systems.
Akin the previous mental tendencies we discussed, the key here is to find a comfortable sweet spot. Being too flexible or too rigid is detrimental to our financial health.
If we are too flexible, we won’t stick to a financial strategy long enough for it to bear fruit. Take the dollar-cost-averaging strategy for example. The strategy is pretty simple: buy a fixed dollar amount of a particular investment on a regular interval.
A concrete example of dollar-cost-averaging would be to buy $100 of Apple stocks every month. The advantage of the strategy is that we end up buying fewer shares when the price is high and more stocks when the price is slow. This strategy only works if we stick with it long enough to have our monthly investments average itself out. If we use the strategy just for a few months because we are too fickle minded, we could end up lucky by buying low or unlucky by buying high, but we will not benefit from the idea behind the strategy.
Another disadvantage of being too flexible is that we would tend to chase the next shiny new investment that is being hyped. Investments are like planting trees, they need time to mature. If we move money too fast out of our money-making investments, we might miss out on earning opportunities when the price rises.
Being too mentally rigid is harmful to our pockets as well. We might be in danger of sticking to money-losing investments longer than we should. Mental rigidity makes it harder for us to admit we are wrong.
Rigidity also causes us to ignore contradictory news and advice that we read. Because of our stubbornness, we will not be able to integrate new ideas and strategies into our personal finance strategies.
It is up to us to find an ideal spot on the flexibility vs. rigidity spectrum. The key here is to persevere long enough with an idea or investment to reap the benefits but to be flexible enough to admit that we are wrong when we see enough negative indications.
It pays off to understand ourselves better
When we fail at implementing certain financial strategies, we can be too quick to blame our lack of discipline or financial competence. Before we do that the next time, we can first take a moment to learn more about ourselves and our natural tendencies.
Understanding our natural tendencies better give us better insight into our individual decision-making process. With awareness, we can make more conscious personal finance decisions. Moreover, we can use our tendencies to adapt finance strategies to our unique personalities.