From our genetic disposition to our environmental influences, each person’s mind works uniquely. And that includes the way we think about money. The psychology of money can help us understand the emotions and thinking patterns that drive spending, saving, and borrowing. And self-awareness is a key tool for creating healthier financial habits.
What is the psychology of money?
You’re standing in the checkout line at the store. Bread, coffee, dog food, candy bar — wait a second. That wasn’t on the list. Oh, and the chips? Those weren’t on the list either.
Doesn’t sound like a big deal, right? It’s just a few extra dollars for a snack.
Without giving it much thought, you’re suddenly sinking your teeth into a last-minute bite of chocolatey goodness or enjoying the satisfying crunch of potato chips on the ride home from the grocery store. Maybe you’re sipping an ice-cold soda or chewing a refreshing piece of minty gum.
According to a recent SlickDeals survey, if you’re like 72% of Americans, then you don’t mind paying an extra $5 or $10 for the irresistible satisfaction of impulsive purchases at the grocery store.
But what if those last-minute purchases added up to more than $5,400 a year? Most might agree; that amount of money could pay off that lingering balance on a credit card, cover moving costs, or even boost an emergency fund.
The truth is we don’t always consider long-term savings when we make those purchases. We are driven by a complex set of emotions and mental shortcuts that psychology has only begun to unravel.
The psychology of money is the study of how people behave with their money.
Instead, it’s about understanding the thinking patterns that drive us to spend and save. Once we recognize why we spend and gain foundational knowledge of how money works, we can change our future and help us reach our financial goals.
The illusion of rational choice
The next time you’re about to make a purchase, big or small, take a step back and check in with yourself.
How’s your day going? What do you feel when you’re ready to spend? Excitement, sadness, envy? How do you feel about those feelings? Pride, regret, shame? Remember, there’s no correct answer when you check in with yourself.
Checking in with yourself can be helpful to do when making any financial decision. Are you driven by long-term goals or short-term gratification? By a need for security or a desire for adventure? These questions will help you start building self-awareness of your financial behaviors and create a window into your own subconscious.
Rational choice theory is the belief that humans are rational beings who make decisions based on logic and reason. This idea stems from the mind of Adam Smith, a Scottish philosopher commonly referred to as the “father of modern economics,” and assumes that people will always make economic decisions that maximize gains and minimize losses.
While plenty of evidence supports many aspects of this theory, especially concerning businesses and organizations, it fails to consider one essential part of human nature — individual impulse.
Did Adam Smith ever have to resist the temptation to buy a refreshingly cool soda on a hot day as he cashed out at the grocery store? Would he have demonstrated rational decision-making when a coupon for 50% off all home goods for his favorite online retailer landed in his inbox on Black Friday?
Considering he died in 1790, we may never know for sure.
But you can be sure of one thing: in behavioral economics, people don’t always follow strict philosophical rules. As a result, most people tend to make irrational economic decisions to the tune of $324,000 throughout their lifetime.
What drives financial behaviors?
So, if we aren’t driven by rational decision-making, what drives us to spend, save, or borrow when it comes to our own money? In the psychology of money, three primary motivators drive financial behaviors: mindset, biases, and emotions.
Financial mindset
Financial mindset is our overall attitude and beliefs about money. Our experiences, family, culture, and society shape mindsets. How did your parents talk about money when you were a kid? How did your family’s financial situation make you feel around your friends?
Financial biases
Financial biases are our judgments about investments or purchases without knowing the facts. They can lead to assumptions that may not be accurate, and whether we realize it or not, those biases impact financial decision-making daily. Are you saving for a long-term goal but carrying a balance on your high-interest credit card? Do you have “fun money” you feel comfortable spending? But other money you don’t feel like you can’t tap into?
Personal emotions
Emotions are also powerful drivers of financial behaviors. Sensations like fear, joy, or sadness caused by bursts of neurotransmitters like dopamine can lead us to make decisions we wouldn’t otherwise make. As a result, they can significantly impact our financial wellness if they’re allowed to rule our spending habits.
When we understand what drives us to spend, invest, or save, we can make better financial decisions aligned with our goals and values.
Here’s a breakdown of everything you need to know to manage your finances better.
Understanding your financial mindset
Everyone has a unique relationship with money and finances. Your lifetime experiences, identity, and social environment primarily develop how you perceive financial resources.
For example, during the height of the COVID-19 pandemic, single moms struggled to keep themselves and their families afloat. As the primary caretakers and, in many cases, the primary breadwinners, the layoffs and disruptions caused by shutdowns forced them to switch into full survival mode overnight. With added stress from income uncertainties and grueling hours of housekeeping and caretaking, it’s no surprise that this could cause a change in how these parents feel about their money.
Experiences similar to this example can lead to what financial psychologists call a scarcity mindset.
What is a scarcity mindset?
The concept of a scarcity mindset — the belief that money is limited rather than flowing — was officially coined in Stephen Covey’s bestseller The 7 Habits of Highly Effective People.
A scarcity mindset is associated with anxiety, fear, hoarding, and even greed. It can develop when someone also believes that they have limited wealth, limited time, and limited opportunity. It’s important to recognize that a scarcity mindset can develop from very real, traumatic, and sometimes chronic circumstances, like the example of single mothers during the COVID-19 pandemic.
While scarcity can come from circumstances and experiences, the fear from that mindset can cause people to continue building those same negative associations with money. For example, if you believe you’ll never have enough money, you may be less likely to make small changes to change your financial situation.
A scarcity mindset may cause you to write off the importance of minor cuts to your budget, such as canceling subscriptions or learning to save money as a couple. However, the cumulative effect of cutting back on discretionary spending can add up—reducing your spending by just $50 a month leaves you $600 wealthier by the time the holiday season rolls around.
Small changes in discretionary spending aren’t the secret key to wealth, but it is one piece of the pie that can improve your financial wellness.
What types of scarcity thoughts exist?
- You believe you will never have enough money, no matter how much you earn.
- You believe there are not enough hours in the day, so you must make the most of every minute.
- You believe that there are limited opportunities for success, so you must seize every opportunity that comes your way.
- You believe there is not enough money to go around, so you must hoard what you have.
If you’ve thought about any of the above, don’t worry. There are things you can do to shift your mindset.
Checking in with your relationship with money and financial education can help change the way you think about money. If you understand how money makes you feel, how money works, and how to make money work for you, you can shift your thinking, feel less stressed about managing your finances, and adopt a healthier financial mindset.
What is an abundance mindset?
An abundance mindset is believing you can always make more money and find more opportunities. An abundance mindset helps you feel less stressed about your current situation and confident in improving your finances. This abundance mindset is essential for developing better financial habits because it helps you focus on your goals. When you believe there will always be opportunities for more money, you will likely take the necessary steps to make more money.
You are also more likely to be open to new things and willing to take risks that could lead to greater rewards.
While having an abundance mindset doesn’t mean risking more than you can afford to lose, it does mean accepting that some things won’t go exactly as you planned, but all for the chance to make significant changes.
Understanding your cognitive biases
Along with your attitudes toward earning, it’s helpful to understand your tendencies toward spending and purchasing decisions. Now that you’re halfway through this article, it won’t surprise you that subconscious beliefs and cognitive biases drive many financial decisions.
What is cognitive bias?
A cognitive bias is a misjudgment due to an assumption someone makes. Unfortunately, cognitive biases often dictate your spending habits, and marketers use them to get you to spend money. Let’s investigate ways to become a more “rational consumer” and keep more dollars in your pocket.
Behavioral biases that affect purchasing behaviors
Understanding these cognitive biases is critical to understanding the psychology of money. Between clever marketing schemes and human judgment errors, falling prey to your cognitive biases can cost you a lot of money. So, let’s look at some biases that affect your spending and financial wellness.
Present bias
Present bias refers to the tendency to settle for smaller short-term gains rather than more considerable long-term gains. For example, buying certain household products in bulk is more expensive upfront, present bias tells you to not buy in bulk because you’re spending less in the moment. The problem is, even though you’re spending less upfront, you end up spending more over time.
The decoy effect
Have you ever wondered why so many offers exist as small, medium, and large packages? And the medium option usually seems to be the worst value for your money. This marketing trick is called the decoy effect, and it’s one of the oldest marketing tricks in the book.
When only two offers are available, it’s easy for consumers to choose. But when adding a third option, the more expensive choice seems like a better deal. Overwhelmingly, consumers will spend more when they feel they’re getting the best bang for their buck.
You can avoid the decoy effect by considering your choices before you’re at the register. For example, the next time you’re at the movies, set a budget for snacks ahead of time. That way, you’re less likely to spend extra money on the large tub of popcorn just because it feels like you’re getting a better deal.
Loss aversion
The poet Alfred Lord Tennyson famously wrote, “better to have loved and lost than never to have loved at all.” As it turns out, that’s not true; people don’t like losing things. Loss aversion is why you feel the adverse effects of losing money much more strongly than the positive effects of gaining it. Loss aversion isn’t necessarily harmful, but it could prevent us from making safe investments and increasing our net worth as a result,
Overconfidence
Research has shown time and time again that we think we’re better at things than we are. This is especially true in the case of investing. Overconfidence can affect your purchasing decisions even if you’re not playing the stock market.
For example, you may be overconfident in your willingness to wake up early and go to the gym daily. Unfortunately, your overconfidence could ultimately lead to you wasting money on a gym membership that you don’t use enough to justify the expense.
Scarcity heuristic
In the late 1990s, a bizarre craze swept the nation–Beanie Babies. Ty, the toy manufacturer behind the stuffed animals, designed thousands of different Beanie Babies but only produced a limited number of each. Because of this scarcity, the Beanie Baby trade boomed–for a while.
Soon, however, the Beanie Baby fad ended, and those who had paid exorbitant amounts of money for “rare” Beanie Babies were left high and dry when the market crashed. The takeaway from the Beanie Baby Bubble is this—we’re more likely to buy things when we perceive them as scarce.
Sunk cost fallacy
The sunk cost fallacy refers to our tendency to continue investing in things we’ve already invested in, even if the costs don’t outweigh the benefits. So, for example, if you’ve invested lots of time and money into fixing up an old car, it’s likely that you’ll continue—even if it would be more rational to ditch the project and buy a new car.
These biases and mental shortcuts collectively influence everything, from how we spend our money to the stocks we buy and sell. But arming yourself with knowledge of these biases sets you up to overcome them.
Emotions that drive purchasing behaviors
Emotions are a huge driver of our purchasing behaviors. Studies have shown that 95% of our purchasing decisions occur subconsciously. We may think we make informed, rational decisions – such as comparing brands – but most of those decisions are unconscious.
Financial stress
Financial stress can drastically affect our behavior patterns when spending, saving money, and investing. Stress may inspire you to save your money and feel like you have control over the situation. Conversely, stress may cause you to increase your spending—especially on things that you can justify as necessities.
Worrying about money doesn’t make you richer. Research has repeatedly shown that money only buys happiness up to a certain point. Once your needs are met, a higher income leads to a classic case of diminishing returns.
Learning to manage your money with wisdom can help alleviate this stress and help you look forward to expensive life events like higher education, marriage, or purchasing a home.
Self-esteem
The effect of financial success on self-esteem is nuanced.
Research has shown that compulsive spenders typically have lower self-esteem than those with more stable spending habits and that compulsive spenders “have beliefs about money which reflect its symbolic ability to enhance self-esteem.”
One study found that those who base their self-worth on their financial status are more likely to compare their financial success to others. However, the same study found that people whose self-worth is contingent on financial status experienced more financial hardship than others—and more anxiety.
Shame
Rich or poor, it’s common to feel shame about your financial status. Those who have achieved great wealth often feel shame about their fortunes. But conversely, shame also is a common sentiment among the less fortunate, who may think that their financial insecurity reflects their worth as human beings.
The bottom line
There are a lot of factors that affect our relationship with money – some negative and some positive. By building awareness around what drives us to make financial decisions, we can use psychology to our advantage and achieve even greater financial goals.
Post Disclaimer
Julep is not a financial institution, financial advisor, or credit repair company, and does not provide credit repair services of any kind. The information provided is for general educational and reference purposes only. The information is not intended to provide legal, tax, or financial advice. We do not propose any guarantee that the information provided will repair or improve your financial profile. Consult the services of a competent licensed professional when You need financial assistance.