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Five Ways Our Psychology Affects Our Money

Posted By Jim On 08/01/2012 @ 7:10 am In Personal Finance | 6 Comments

In college, I took a few psychology classes because I found the subject fascinating. I love reading about human psychology, along with economics (and later behavioral economics), because I felt like it gave me a cheat sheet on the world. It’s amazing the number of similarities we all share in our psychology despite having different backgrounds and childhoods.

The part that might be of interest to Bargaineering readers are the ways our psychology affects our finances. I thought I’d find a few that are the most striking and see what we can learn from them.

Spotlight Effect

The spotlight effect is where you overestimate how much you think others are paying attention to you. In reality, they aren’t paying as much attention. How does this manifest itself in your finances? Let’s say your friends are all going on a trip that you can’t afford. You could go if you charged everything on your credit card and paid it off over a few months. Do you go because you don’t want your friends to think badly of you? Or do you skip out and save yourself the interest payments? You are making decisions based on other people’s opinions, rather than your own situation and that’s dangerous. It stinks to miss out on a fun trip but is it worth putting yourself into that kind of financial hole? What if I told you that the other people probably won’t even notice? And they certainly won’t think badly of you for missing it!

Fundamental Attribution Error

This is a common one, especially when you start talking politics, and it’s where you have a tendency to put more blame on the person’s behavior rather than the situation. It’s a tendency to believe that someone who needs assistance, such as welfare, is lazy rather than unlucky. Someone who is on food stamps is probably not working hard enough to earn money for their family, rather than the any number of reasons why they can’t earn more. The error has a flip side too – there’s a tendency for you to look at the events in your life as having a greater contributing factor to your failures, rather than inherent qualities. If you can’t find a job, it’s more likely that you are unlucky, that there are no jobs for you, rather than you not having applicable skills or you simply being lazy.

Hedonic Treadmill

The hedonic treadmill is the idea that we return to a relatively stable level of happiness even after significant positive or negative changes. The theory leads to the idea that if you make more money, you’ll return to a relative stable level of happiness because your desires and expectations rise with your income. If you get a big raise at work, your happiness will increase but so will your desires and expectations. Eventually, your happiness level will move back towards your normal, though your expectations will have risen. The big takeaway from this idea is that you won’t be much happier, for much longer, just because you make more money. Even with a big raise, your happiness level will usually revert back to “normal” for you. Money really can’t buy you happiness, it can only buy you things.

Risk Aversion

It’s well understood that we, as human beings, hate losing more than we enjoy winning. It’s known as risk aversion and it’s something that kept us alive eons ago. When you were in the jungle and there was a dark patch in the woods, we didn’t know if there was going to be food in that dark patch or a lion waiting to eat us. So rather than go after the win, we avoided the potential loss. Nowadays, these things aren’t dark patches with lions or food, they’re extended warranties and other insurance packages. Be wary of them because they prey on your fear of loss and alleviate that fear with expensive packages. Many credit cards offer warranty protection programs [3] that double the manufacturer’s warranty, making the extended warranty redundant.

Experiences Over Things

Here’s a subject we’ve discussed a few times in the past [4] – we tend to value experiences over material things. There’s a number of reasons why this is true but the one that resonates with me is the idea that we mentally revisit our experiences and tend to remember the good things about them. Things simply get older. We may attach special meaning to some things but those generally are indicators about the associated experiences, like souvenirs. Souvenirs are important not because of what they physically are but what they remind us about those experiences.

It’s always interesting to read about how human psychology plays such a large role in our finances.


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[3] warranty protection programs: http://www.bargaineering.com/articles/extended-warranty-worth-cost.html

[4] discussed a few times in the past: http://www.bargaineering.com/articles/memories-appreciate-stuff-depreciates.html

Thank you for reading!