WHY FINANCE IS HARD: Understanding Human Nature, Corporate Tactics, and Practical Solutions
Finance is hard and don’t let anyone tell you otherwise. Or else everyone in finance would be a millionaire, right? I’ll give three examples of why I think finance is hard and how we can perhaps overcome the difficulties and understand that it is not in our nature for finance to be easy.
1.) Humans are not financial optimization machines they have Emotions!
The definition of finance according to Corporate Finance Institute is:
“Finance is defined as the management of money and includes activities such as investing, borrowing, lending, budgeting, saving, and forecasting.”
Links to Additional Resources: Financial Planner
As human beings we are emotional, biased and not always mathematically optimized in our choices. So don’t blame yourself for making finance mistakes because we are not inherently wired to always make the optimized choice. We want that chocolate bar, champagne, designer shoes…. today not tomorrow. Finance would tell you that not consuming today, saving, investing, compound interesting that amount and consuming later would yield to a higher quantity of consumption in the future.
However, as a human being if I have 1000 today I would like to buy the champagne or the designer shoes and consume it, but finance would tell you to invest say for simplicity’s sake at 10 percent annual and you can buy 1.10 times champagne in one year or approximately double in 7 years.
I also think that hundreds of years ago we were primed to stay alive and consumed the food we saw, we didn’t think about budgeting our food…So inherently we are going against our nature.
Corporations know more than us, The deck is stacked against us.
2. All the large corporations have figured out that making optimized choices in finance is not in human nature and they have promotions and marketing preying on that fundamental dynamic.
Some everyday examples: Corporations have figured out that if they can get you to sign a gym membership, that it is highly likely that you will not cancel it.
Credit cards send interest rate promotions for 0 interest for 12 months hoping that you will succumb to your emotions charge up more than you can pay and be hooked for interest payments after the 12 month promotion.
3. You have to be Primed for it, our brains can’t handle it, we use heuristics (short cuts)…
I went to a conference once and a Nobel prize winner professor was speaking of behavioral finance and he gave an example of something like this which I am brutally paraphrasing here, but he said something like this, if you go to the super market and buy a gallon of milk and there is only one person in you household who uses it for coffee, you probably won’t go though even half of it and you’ll throw it out and he said you will make that mistake possibly a few times more but on your fourth attempt at buying milk you will realize that you don’t need a whole gallon and you’ll buy half a gallon…He said that unfortunately when it comes to finance, we don’t have enough frequency of interactions / experiences of making these small mistakes to learn and be “primed” to choose the optimized size of milk carton.
Solutions
I think the solution to Finance is hard lies in the fact that we have to realize it’s hard and reflect back on the challenges and be more reflective in our choices.
For example, if you do sign up for the membership make sure you have a Nudge (calendar reminder) in place to question the membership cancel it if you’re not using it.
Try to question more financial choices and do more research before making impulse purchases.
Have a budget in place for each area of spending category. Like safety brakes on a bike.
Realize that human beings are not primed to make optimized choices, seek out resources and tools to make a better optimized choice.
KEY POINTS:
The inherent difficulties in finance due to human nature.
The influence of corporations on financial decisions.
Practical advice for overcoming these challenges.