Recent studies suggest that when it comes to making financial decisions, consumers act based on their understanding of the choices available to them, which often, ends up being the less-optimal choice.
Experts suggest that consumers can reduce this phenomenon by increasing their financial literacy, working to understand what the choices available to them are. This way, the criteria consumers base their decisions off of, is not mere intuition alone.
In one study, chronicled in the June 2013 issue of the American Marketing Association’s Journal, participants chose between two life-cycle funds — low- and high-risk. When the high-risk fund was described in a complex way, participants chose the low-risk fund. When the low-risk fund was explained in a more complex manner, the high-risk fund was picked.
So how can consumers counteract this physiological phenomena? In order to make the best financial decision, buyers are encouraged to understand their options and to know when to trust their gut feeling.
Trust your gut?
According to Helen Fisher, PhD, “Intuition is really learned expertise in disguise.”
Intuition can play a positive role in decision-making, as long as it’s is balanced with rational information. Gut instinct can certainly be beneficial for an informed and experienced consumer. It’s still advised that before giving in to a gut instinct, consumers should get a second opinion from a knowledgeable party.
Knowledge is key
Improving someone’s financial literacy is an important part of the decision-making process before determining whether or not to make the purchase. According to the Consumer Federation of America and Primerica, two out of three Americans have made at least one “really bad decision,” and nearly half admitted to making more than one poor financial choice.
Go online and educate yourself as much as you can, before making your purchase. If you’d rather be around humans, head to your local library or bank and ask whether they hold free financial literacy courses.
Rules of thumb
Additionally, there are a few good rules of thumb on how to set yourself up for financial success, which include:
- Making an emergency reserve fund that has at least 12 months worth of living expenses.
- Avoiding investments with hefty fees (sticking to no-commission index mutual funds will give you a 1-2 percent advantage over investing in actively managed funds that come with a sales charge).
- Resisting caving in to emotions to rule your financial choices. Two common emotions that influence financial decisions are fear and greed. Too much greed and you take on heavy risk. Too much fear, and you take on no risks at all. To pad yourself from emotional mood swings, start building a diversified portfolio that balances your risk across different asset classes (like stocks, bonds, cash, and commodities).
- Purchasing the right amount of insurance coverage for you, which can be calculated using a life insurance calculator.
- Investing safely by limiting your investment to a percentage of your net worth, ideally under 10 percent.
- Refusing to let yourself be taken advantage of due to financial ignorance. If you have a financial advisor, find out how they are compensated — if they are paid on commission, their motives to sell you financial products will be swayed based on the potential pay cut for them.
When it comes to making financial decisions, there are no shortcuts to ending up with the best choice. Consumers should focus on improving their financial literacy, and when in doubt, trust your gut, too.