Sunday, December 23, 2007

Behavioral Finance – Psychological Denial

This is the second in a series of posts about common human misjudgments. The series is based on a Charlie Munger speech at the Harvard Law School in 1995.

2. Psychological Denial
When reality is too painful, people will distort it.

Charlie Munger gives the example of how some mothers appear to have unwavering support for their sons that have been convicted of crimes. Even in the face of overwhelming evidence and hard facts, some mothers will continue to think that their sons are innocent of any crime or wrong doing. That's simple psychological denial. The denial results from the fact that reality is too painful to bear, so they distort it until it is bearable.

In the case of personal finance, it is very common for people to deny that they have a financial problem. The thought of owning up to our expensive credit card habits makes us very, very uncomfortable. So we deny that we have a problem at all. One survey found that 58 percent of respondents claimed to pay off their credit cards in full every month. This is in contrast to studies that show that number closer to 40 percent. But remarkably, only 3 percent of respondents believe that most other people pay off their cards in full.

Not only are people denying the fact that they are not paying their cards off, but they are refusing to believe any body else is paying off their cards.

We all do this denial to some extent as it is a common psychological misjudgment.

So what can we do about it?
Remember the first step to improving a weakness or solving any problem is to recognize it. Now that you are aware of this common psychological misjudgment, look within yourself to find anything that you are in denial about.

There has got to be something. Let’s just stick with personal finance, for now. Perhaps you are outspending your earnings? In this case, you may avoid looking at the facts. For instance, do you pay the minimum amount due on your billing statements and then toss them with barely a glance at the total amount owed? Do you know what your credit card interest rate is? Are you trying to deny the situation by ignoring it?

Or maybe you are not saving enough for retirement. Do you avoid thinking or planning for your long term future? You may feel that you do not have the income to fund your retirement without impacting your lifestyle, so you choose not to think about. Reality can be tough. But, the reality is that you must save a part of every paycheck, even if it’s just a few dollars, to fund your retirement. Pay your future self first by putting aside a small amount for your retirement from every paycheck.

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