This guest blog was written by Chris Budd, who wrote the original Financial Wellbeing Book as well as The Four Cornerstones of Financial Wellbeing. He founded the Institute for Financial Wellbeing and has written more than 100 episodes of the Financial Wellbeing Podcast.
Sometimes, when we make major financial decisions, the question of money must come first. Specifically: “Can I afford it?” and “Is it good value?”
However, there are other times when this question of affordability and value for money gets in the way of good financial decisions. Here are a few examples, and some tips on how to make financial decisions that support wellbeing.
The endowment effect
There is a behavioural bias known as the endowment effect. This is where we value things that we already own more than the same thing if we did not already own it.
In one experiment carried out in 1990, people were shown a coffee cup and asked how much they would pay for it. Half of the respondents were given the mug for a week first, and half were seeing it for the first time. Those who already owned the mug valued it twice as highly as those who did not.
This common tendency can lead to you wanting more money when you sell an item than you would be prepared to pay to buy it yourself.
This can spill into investing as well. For example, you may not want to sell investments even if they are no longer performing well, especially if they were inherited.
Similarly, you might value your own house higher than people are willing to pay for it.
What is value?
I once had a wealthy client who wanted to buy a painting. It was a lot of money – £20,000.
We had a long discussion, and did some financial planning to show that he could afford to buy it. He and his wife loved the look of the painting, and the subject matter of the painting was very personal to him. There was a particular place in their house where he and his wife wanted to hang it. They had several personal viewings at the gallery. In short, he really wanted that painting.
He hired an art specialist to give him advice. The specialist researched the history of the painting and discovered that the gallery had bought the painting only a few months previously for just £2,000. The client felt that he was going to be ripped off and decided not to proceed.
The net result: They don’t own that painting that they really wanted and could afford.
By focusing only on the financial element of the transaction, the client ended up not getting what he wanted.
Assessing financial decisions
Here are a few criteria one might use when making a significant financial decision. You might allocate points to each one. This process might help make the decision a little clearer.
1. Affordability
Clearly, it would be foolish to make a purchase you cannot afford, or an investment where you cannot afford to lose the money. Getting into debt to buy something you want but don’t need is unlikely to be a wise move.
However, how do you know it’s not affordable? If you have a financial plan, it can be used to test whether the purchase or investment is likely to delay achieving future objectives ,or might create financial difficulties in the long term.
Sometimes we are put off buying or investing in something because it seems like a lot of money, rather than considering whether we can afford it or if it is a good thing to buy.
2. Emotional wellbeing
Many people choose to pay their mortgage off early if they can afford to. This can be argued to be a poor financial decision – the return on investments might be higher than the interest on the mortgage. However, the feeling of being mortgage-free and living in a house that you own, for many, far outweighs a small improvement in their financial returns.
Sometimes, it is important to listen to our emotions.
3. Emotional reactions
We all have many emotional reactions which affect the decisions we make. Sometimes these emotions keep us safe and help us make good decisions. Sometimes, however, they are less helpful, as they are informed by a previous experience which may not be relevant to the current decision.
If you have an emotional reaction to a proposed financial decision, it can be a good idea to slow down. What is the cause of that emotional reaction? It might be an indication that this is not the right decision for you. It could also be that something has happened previously that you are applying inappropriately, and which is getting in the way of a good decision. Discussing this with an independent third party, such as your financial planner, may be helpful.
Focusing on the wider issues around a purchase or investment, not solely on the financial aspect, can result in better financial decisions. In this, “better” means a decision that is appropriate for your financial circumstances, and thereby leaves you feeling more comfortable and confident.
Please note: This blog is for general information only and does not constitute financial advice, which should be based on your individual circumstances. The information is aimed at retail clients only.
The value of your investments (and any income from them) can go down as well as up, and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
