Money issues should be arithmetical but they are often psychological. When making money decisions we end up being irrational. Those decisions make us lose financial positions, expending more or earning less than we could.
There are several articles about money psychology and one of the keys is making the unconscious conscious. We need to know what are the mechanisms about money and how they work when making us take a bad money decision. If you know the mechanisms, you can often realize what to do before making a mistake. The main objective is to reduce cognitive biases and avoid marketing traps.
Irrational decisions and money: cognitive biases
We can’t talk about money psychology without knowing the term cognitive biases. These are mental shortcuts that our brain uses to process information and make decisions. It’s a way of optimizing resources because taking each decision from zero it’s not manageable.
However, there’s another side of the coin. The biases make us work in automated ways that may affect our rationality and personal economy. There are several cognitive biases but the most important three are:
Hyperbolic discounting and irrational decisions about money
The humans are programmed to look for immediate rewards instead of long term ones. We tend to prefer 20 dollars now than 50 dollars in the future. We prefer spending rather than saving. This bias impedes people to correctly plan a financial strategy and it exposes us to greater loses.
Aversion to loss bias
This bias indicates that humans do what they do to avoid losses rather than obtaining earns. We tend to be conservative and we let good investment options pass.
Mental accounting bias
Lottery winners spend their rewards easier than the money they earn working. This bias gives a different value to money according to its origin or destination. Easy comes, easy goes would be a phrase to explain it plainly.
The nature of money
Another reason to explain why we are not rational when dealing with money is the fact that money is a powerful status symbol. The evolution has made humans think that when you have a higher status, you’re better. Rich people wants more money, even more than those who don’t have a lot of money.
Think about a rich person such as Jeff Bezos. One million dollars its nothing, but he tries to earn more money with more zeal than another individual. It’s irrational to some extent, but it is explained because we look for excessive benefits. Money is also part of our identity and we can’t avoid comparing ourselves to those around us.
At the end, money is not a tool to reach and end, but a status symbol. Something the people want to obtain because we use it to create our own identity. Money causes humans to behave apparently irrational in order to get more money. And we end up taking doubtful decisions.
A classic example of irrational money decisions
Men and women attracted hopelessly to a promise of fast richness. It doesn’t matter if the methods to reach it are obviously doubtful. There are NFTs scams and other digital tulips. Everybody falls in one of these sometime.
Marketing and context influence
Why do we spend money in something we don’t need? Marketing is responsible for these decisions a lot of times. It creates needs for the people. Why do we take a risky decision by betting and not retire when winning? Casinos and bet games are experts in creating a context that encourages irrational financial decisions.
A great number of our financial decisions are purely irrational. We are not really satisfied by them and we haven’t thought about them carefully.
How to avoid irrational decisions with money?
We can’t avoid irrational money decisions at 100%. What we can do is to mitigate them. First of all, we have to know about the biases. This can help you to notice faster irrational decisions. The human reacts defensively by nature.
Systems
The mantra of a good investor is to guide by systems and not emotions. Any domestic economy can be systematized. Our behavior towards money has to be always the same. That can help you to avoid irrational decisions.
If you save a portion of your salary automatically, you won’t need to worry about spending that money in something you don’t need.
Discipline and budget
Organize your economy. There’s no other way to improve your economy than planning your expenses carefully. It’s not as glamorous or innovative as you would think. That’s because rational thinking can be boring too.
Small tips to avoid irrational decisions with your money
- Compare prices and don’t let offers to blind you.
- Set up your financial objectives clearly.
- Think carefully before taking a decision. You don’t need to invest immediately. It’s good to take 48 to 72 hours before making a big financial decision.
- Learn about financial culture and investments.
Irrational decisions will still appear, but we can reduce them if we start to know about them. It’s just a matter of will.