Note: Post may contain affiliate links.
As the old saying goes, personal finance is ‘mostly personal and a little bit financial.’ Long-term growth and success rely more on our habits and behaviors than on complex knowledge and advanced strategies. Learning a few key points on the psychology of money can go a long way to building the right mindset for prosperity.
Let’s look at a few far-reaching psychological concepts that play an outsized role in our financial lives, including some of the biases and fallacies that can point us in the wrong direction.
8 Crucial Money Psychology Concepts
Human cognition can be messy. Each of us carries a collection of cognitive biases, irrational beliefs, and behavioral quirks. When we make decisions about our money, this can, unfortunately, lead us down the wrong path.
Understanding each of the money psychology concepts below will help you approach your finances more rationally and avoid some of those poor decisions that stem from cognitive bias.
Optimism bias is the natural tendency to overestimate the likeliness of positive outcomes and underestimate negative ones.
In terms of money, optimism bias can lead to reckless decisions and insufficient planning. That can include:
- Investing heavily in risky products
- Carrying insufficient insurance
- Taking on excessive consumer debt
- Ignoring your emergency fund
No one looks forward to dealing with failed investments or significant unplanned expenses (like vehicle repairs or medical bills), but the risk is there. When misfortune does come, this optimistic bias leaves us in a precarious position.
The ideal approach to finances is to hope for the best but prepare for the worst. It’s great to be optimistic, but not when it gets in the way of sound decision-making.
The polar opposite of optimism bias – pessimism bias – can also play an insidious role in our finances. Pessimism bias, (also known as negativity bias), draws our attention away from positive circumstances and causes us to weigh negative stimuli more heavily.
Negativity bias can cause us to subconsciously exaggerate the impact of market downturns in our minds and overreact to perceived financial dangers. One typical instance of this is people rushing to sell a stock that has decreased in price over a short period. It is also what causes many people to cash out some or all of their investments in fear of future market conditions, almost always missing out on gains in the process.
The financial media is no help here, constantly rushing to predict the next market crash or recession, usually inaccurately. To steer clear of this bias with your money, remember the mantra, “if my strategy hasn’t changed, then what I’m doing shouldn’t change.”
Human beings’ unparalleled ability to adapt to new settings and situations is one of our greatest strengths, but it can also get us into trouble with money.
While adapting to adverse scenarios works well for our survivability, we can also adjust to pleasant things we enjoy. Over time, things that were once exciting and new become familiar. This effect is called hedonic adaptation.
Due to hedonic adaptation, many spend most of their adult lives buying bigger, fancier, and nicer things. As a result, they end up on the ‘hedonic treadmill,’ chasing fulfillment that always stays just out of reach.
Stepping off the hedonic treadmill and seeking other avenues to fulfillment can be tremendously effective for both your happiness and your finances.
Sunk Cost Fallacy
The sunk cost fallacy describes the human tendency to keep doing something we have started, even if it isn’t working out. In particular, once we have committed time or money to something, we will likely stick with it.
For instance, imagine you have invested money in a product or business, and that investment has been performing poorly with no signs of future improvement. You may feel inclined to keep your investment or add to it, even if the more rational decision is to reevaluate your strategy.
As the saying goes, ‘don’t throw good money after bad.’
To overcome the sunk cost fallacy, try to evaluate financial decisions as if you were new to the situation, evaluating it for the first time. This fresh-eyed perspective reduces the burden of your past choices and allows you to consider the field as it stands today.
Humans are social creatures, and we love social proof. So if you are considering a new microwave, it can be helpful and affirming to know that your neighbor has used the same one for years and loves it.
Unfortunately, this helpful instinct can sometimes endanger our finances, especially investing. For example, when your coworker recommends a stock, fund, or shiny new cryptocurrency that has performed exceptionally well for them in the past few months, that is, unfortunately, no indication of how it will perform if you were to invest in it today.
At a large enough scale, social proof can also trigger a groupthink, gold rush, or bandwagon effect. When everyone around you is talking about and buying into the latest hot investing trend, it is a reliable sign that area of the market is flooding.
Long-term investing usually works best for those who choose a simple, reliable strategy and stick to it regardless of what’s popular today.
The Pesky Joneses
“Keeping up with the Joneses” is a cliche so old that you can almost imagine it was a problem for the first people who ever had neighbors. Our tendency to set our values and desires based on the people in our vicinity is strong and closely tied to our penchant for social proof.
It is standard advice to quit keeping up with the Joneses. The problem is that almost no one is doing it on purpose. The motivation to spend money and buy nice things to match the people around us is mainly subconscious.
The only cure to keeping up with the Joneses is often to create distance from them. Surround yourself with people that share similar money values to you. When the people around you are a positive financial influence on, great things can happen.
The Gambler’s Fallacy
The gambler’s fallacy is the often-unconscious expectation that past outcomes will unduly influence future events. For example, a roulette player might see that the last six spins in a row have landed on black and think that the next is sure to hit red. Although in reality, the probability of the next roll landing on red is the same as it always is, about 47%. The previous spins are irrelevant. Hindsight offers no help in a casino.
We see this flawed logic in the stock market too. Investors often watch a stock that has been falling for some time and think it will surely go up soon. Alternatively, some may assume an investment that has been soaring up is due for a crash. Neither is necessarily true. The overconfidence people put in this illusion often leads to bad decisions.
Sound investment decisions should consider an asset’s underlying value as it stands today and its prospects for future growth. Past returns may feel relevant, but they generally do not influence what is yet to come.
The Scarcity Mindset
The scarcity mindset is a common bias that creates the looming feeling that we don’t have “enough.” This idea can range from a broad and non-specific sense of scarcity to granular worries such as not having enough food in the pantry, clothes in the closet, weekend entertainment, etc.
The scarcity mindset, like the hedonic treadmill or keeping up with the Joneses, drives people to continually buy more things, fill more spaces, and generally expand their lifestyle. But unfortunately, the scarcity mindset cannot be satisfied in this way. It is driven more by our emotions than a rational need, and we cannot satiate it through material means alone. Practices like meditation, positive thinking, and keeping a gratitude journal can help you heal from the scarcity mindset and build up its healthy opposite within you: the abundance mindset.
Practicing the Psychology of Money
When it comes down to it, understanding the psychology of money is potentially more valuable to your finances than any strategy, advisor, or hot stock tip. Even a cursory familiarity with some of the psychological concepts that influence your financial decisions can help you to prepare and make better long-term financial decisions.
Humans are full of quirks, biases, and oddities of all sorts. Understanding these peculiarities help to prepare for and circumvent them when they could otherwise cause harm. Making decisions doesn’t always come naturally to us. Ultimately, it’s best to remember that none of us is perfect and keep doing our best to work with the mindset and knowledge we have.
This article originally appeared on Finance Quick Fix.
Sam is the founder of personal finance and self-improvement blog Smarter and Harder. His mission is to start exciting new conversations that empower people to improve their work, lives, and money, and have fun doing it. In all things, he strives to lead with positivity, understanding, and more than a bit of enthusiasm.