With the number of magazines, blogs, and books dedicated to personal finance you’d think we’d all have achieved financial independence by now. How is it then that most of us are still struggling day to day to make ends meet, just one job loss or illness away from financial devastation?
Financial gurus smugly tell us to live below our means, pay ourselves first, avoid lifestyle inflation, and then pat themselves on the back. Mission accomplished.
But this makes about as much sense as advising a five pack a day smoker to simply stop buying cigarettes. Wouldn’t bet on it working. How about admonishing the alcoholic to pour out the Johnnie Walker hidden in his bedroom closet? Sounds great. But not going to happen.
No, simple advice will not change behavior, financial or otherwise. The missing ingredient to our fiscal success may rest in our understanding the psychology that drives our spending.
Once we understand the underlying psychological motivations that guide our financial decisions can we effectively change our financial lives. Let’s take a look at a few of the psychological forces that influence our money habits.
Social Conformity Doesn’t End in High School
By ourselves most of us tend to make rather rational decisions. Yet when confronted with the contradictory actions of those around us we often concede to the less rational alternatives.
Psychologist Solomon Asch conducted classic experiments in the 1950′s illustrating just how susceptible we are to the influence of others. College students were asked to complete a simple task. They were to match a line on one flashcard with one of three lines on a second flashcard – a task that any five year old could complete.
But there was a twist. All the participants read their answers out loud and all but one of the students were actually decoys, part of the group conducting the study. At one point in the experiment all the decoys would start providing the same wrong answer.
Would the student follow the decoys and also give the wrong answer, or would he stick to his guns and give the answer any five year old knew to be correct. Amazingly at least 75% of the students involved in the study at some point in the experiment gave in by repeating the same incorrect answer given by the decoys.
This illustrates the effective power of socialization or, as we called it in high school, peer pressure.
Just as in the experiment even when we know the right “financial answer”, we make the wrong choices because everyone else is doing it.
Although we understand the absolute absurdity of interest only home mortgages, the fact that the people around us are using them makes it acceptable. Intuitively we recognize the value of keeping a car for five or more years, but when everyone else is buying a new car every three years we too may do the same.
The “wrong” financial answer (interest only loans, purchasing a new car every 3 years, using credit cards instead of cash) all become socially acceptable because everyone else says it is. When enough people chose the wrong answer we capitulate.
The Rapidly Rising Anchor Sinks us All
Anchors are mental reference points we use in making purchases. They’re extremely important because our brains make decisions by comparing an unknown quantity to a known quantity – the anchor. Walk into a store and pick up an iron for instance. How do you know if the $30 price tag is too high? You attempt to compare it to the price of an iron you bought before or to the price of an iron you may have seen online or advertised in the newspaper.
The same concept works for higher priced merchandise as well. How does one really know how much a wedding should cost? We again compare the price to some anchor price we’ve heared or read about. If we’ve read in a bridal magazine that the average wedding costs $22,000 then we’ll subconsciously adjust our budget accordingly.
The problem occurs when our anchors get artificially skewed upward. When we hear that Lala Vasquez is planning a $100,000+ wedding or that Chelsea Clinton’s wedding costs in excess of 2 million dollars our anchor price moves artificially upward. Suddenly a $26,000 wedding doesn’t seem so outrageous in context. A $42,000 car becomes reasonable when we see a barrage of athletes and celebrities sporting $75,000, $100,000 even $250,000 sports cars. Paying $700,000 for a home suddenly doesn’t seem like such a stretch when you have images of multimillion dollar homes piped through your television on a daily basis.
The rich our becoming more wealthy than at any other time in US history. Combine this with our fascination and cult like coverage of celebrities and the super wealthy, and we have a whole set of anchors that are being artificially inflated, from homes and cars to clothes and dining.
Childhood Blueprints Influence Our Adult Money Decisions
Spend less than you earn. Sounds easy, yet commonsense knowledge crashes head long into money lessons seared into our subconscious during childhood. The way money was mishandled in our family could leave an indelible mark on the way we treat money as adults.
A child growing up in a household where parents spent recklessly and then scrambled to pay the rent may subconsciously incorporate the same patterns in adulthood. In an attempt to compensate, a workaholic parent showers their children with expensive gifts. As an adult the child may equate expensive gifts with love and subsequently be inclined to display their affection by purchasing lavish gifts as well.
Perhaps growing up in poverty a child promises never to experience it again. As an adult she overextends herself to compensate for what was missing in childhood. Maybe she goes overboard and purchases everything under the sun she never had for her kids.
I’m sure we all can identify money lessons absorbed during childhood that still influence the way we treat money today. Examining what we internalized as kids helps us understand how we handle money as adults.
Gain Control of Your Money by Gaining Control of the Psychology
Yes money success is more complicated than simple statements – pay yourself first, avoid debt, earn more than you spend. The truth of the matter is that successful money management has as much to do psychology as it has to do with the math.
Until we understand the psychology behind our money decisions, we’ll never get our finances straight. Then next time you’re contemplating a major financial decision ask yourself questions. Are you making a particular financial decision or engaging in a particular financial behavior because everyone else seems to think it’s acceptable? Are you willing to pay more for a purse, car, or other expensive item because you’re subconsciously using an over-inflated anchor price? Ask yourself what lessons you internalized growing up that may influence your financial decision making? Once you get in the practice of questioning your psychological motives, you position yourself to make better decisions.
Master your psychology, master your money.
Alonzo Peters wants you to get your money straight and live a financially fulfilling life. Follow him at MochaMoney.com or on twitter at @OurMochaMoney.