How many times have you heard the advice: develop better money habits, and you’ll inevitably see improvements in your finances?
Adults can curb the impulse to shop for unnecessary items online, limit their lifestyle indulgences, and hang out less with people who’re prone to negative behaviors. Evidence shows that habit formation can be applied to teach even young children the foundations of sound financial practices, such as saving money and delaying gratification.
But it’s no secret that building wealth also involves investing money in different ways. Many of them entail a higher level of risk than we’re accustomed to. And having the right habits in place can also shift your attitude, helping you to make better decisions when it comes to risk versus reward.
Building wealth through investment
Assuming you’ve developed sufficient financial discipline to ensure that your income always exceeds your expenses, you’ll end up with a discretionary amount of money each month. Maintain that, and you’ll build wealth over time.
But the rate at which your money grows will be linear. You can improve further by finding ways to earn more or spend less, but you’ll encounter diminishing returns in either direction. There’s a minimum amount of money you must spend to survive. And you can only hustle so much to bring in extra income.
Investing your surplus money is the only way to build wealth at a non-linear rate. This happens through compound interest. If you keep adding to even a fixed-rate investment over time, ROI will grow exponentially.
It makes a lot of sense on paper, but when you’re faced with the decision, it might not seem so clear-cut. We doubt if we can afford to lock up our money for years in a CD. We fear the volatility of the stock market, despite its historic return of about 10% on average. The safer option of a savings account seems appealing, despite its dismal 0.06% average interest.
Fending off bias
The tension you might feel in that situation is common. It’s rooted in an evolutionary mechanism that makes us naturally tend to be risk-averse. When faced with a gamble that could outsize impact on our prospects, we can err excessively towards caution.
At the same time, we can also be incredibly blind to risk, a topic central to the works of risk management expert Nassim Taleb. When presented with the promise of even more of a good thing, we fail to see the dangers of becoming too fragile.
You can see evidence of this daily in our relationship with smartphones. Because they’re so convenient, we’ve allowed them to become such all-in-one devices that they function as wallets, maps, cameras, and default means of interaction. Yours might even contain enough data to replicate your identity. It’s one thing to drop your phone, as you can get the screen repaired quickly, but what if it gets stolen?
Both risk aversion and risk blindness are examples of cognitive bias. Some people can resist this and make accurate judgments where money matters are concerned. These include trained financial professionals, of course, but anyone can develop this skill.
Making it a habit
Changing your attitude towards risk, whether you’re currently too averse or too intrepid, takes a lot of cognitive effort. This is explained by the mechanism of System 1 and 2 thinking, as put forward by psychologist Daniel Kahneman.
Our biases stem from System 1 thinking, which is useful because it operates quickly, with minimal effort or conscious involvement. Overriding these automatic decisions is possible through the intervention of System 2. But it’s a more effortful mechanism that requires voluntary concentration and exercise of one’s agency.
By working on our habits, we can reduce the need for such interventions. System 1 operates on heuristics. Some of these are innate, but others are acquired through learning, repetition, and constant exposure.
There are plenty of opportunities to integrate risk management into your thinking. The pandemic, for instance, puts everyone at risk when they go outside and enter proximity with potentially infectious individuals. You can wear a mask, or you can reflect on the ‘Swiss cheese’ model of risk reduction and decide which layers of protection you’ll need.
Similar decisions crop up when driving, for example. How fast should you really be going, knowing that adding just 1 more km/h can increase collision injury rate by 3%, and fatality rate by 4-5%?
The more you practice evaluating risk in your daily decision points, the better you’ll get at heuristic judgments, and the less effort it will take to overcome bias and remain objective. Of course, that doesn’t mean you’ll always pick an investment that pays off. It simply enables you to make your money decisions free from the influence of fear, emotions, impulsiveness, or the stigma of previous failure.