Our human capital and ability to work is our greatest asset in wealth creation. This blog explores human biases that we are all prone to and how to take these biases into consideration when crafting a budget. In doing so we can guide individuals to harness their human capital effectively to meet their needs and build passive income over time.
Understanding Financial Behaviors: Hedonic Adaptation and Expense Audits
One of the most powerful psychological phenomena influencing financial behavior is hedonic adaptation. This refers to our tendency to quickly return to a baseline level of happiness following significant positive or negative changes. For example:
– A salary increase might initially boost happiness, but as individuals adapt to the higher income, their spending often rises to match, nullifying the financial gain. The is known as the ‘lifestyle’ bias.
– Similarly, cutting unnecessary expenses might feel restrictive at first, but over time, most people adapt and find their satisfaction levels unaffected.
Behavioral science reveals that many financial challenges stem from cognitive biases, such as:
– Present Bias: Overvaluing immediate gratification over future goals.
– Choice Paralysis: Being overwhelmed by complex financial decisions.
Budgeting and Conducting an Expense Audit: Identifying Opportunities for Financial Growth
An expense audit is a systematic approach to reviewing spending habits to identify areas where hedonic adaptation might be inflating costs unnecessarily. By examining expenses through the lens of needs (survival, security, emotional well-being, self-actualization), individuals can:
- Categorize Spending by Needs (approximately 50% of net income):
– Survival Needs: Groceries, housing, utilities.
– Security Needs: Insurance, savings contributions.
– Emotional and Social Needs: Dining out, subscriptions, hobbies.
– Self-Actualization Needs: Education, investments in personal growth.
- Invest Automatically (25%)
When you receive a pay check automatically put part of your earnings into a savings and investment account. The premise of the ‘time-value of money’ refers to a $1 invested today will be worth more in the future.
By identifying the unnecessary expenses, any more savings can be channeled into income generate assets such as a share portfolio, education bond or into your superannuation. It is also important to consider the needs for personal insurance such as an income protection policy.
The success of implementing this will be incumbent on:
– Automate savings and investments to align with future goals without requiring constant decision-making.
– Set vivid, specific financial goals. For example, saving $500 monthly in an investment portfolio where the act of saving with the emotional appeal of long-term security.
- Understanding Your Wants (25%):
It’s also okay to live a little. There’s only so much will power humans have and if you deprive yourself of the little things, the quicker you’ll eventually run out of energy. By keeping your baseline level of costs low, you are willing to enjoy a brief expensive spike every now and then. In other words, don’t buy stuff, buy experiences.
By integrating insights like hedonic adaptation into an expense audit, individuals can realign their financial behaviors with their goals, reducing wasteful spending while maintaining happiness. Advisors, acting as behavioral coaches, play a critical role in empowering clients to leverage their human capital effectively for financial independence and long-term financial security.
