Guest Post

The Psychology of Money

What physics is to the hard sciences, economics is to the social sciences. The enchantment of discovering the laws governing moving bodies in space is what has attracted some of the greatest minds to the world of physics just as the same thrill of discovery has led to the intensive study of moving bodies in a marketplace. Creating economic models based around what rational people have done in the past is a great predictor of what they will probably do in the future, and is what has led to some of the most interesting discoveries in economics. Unfortunately, unlike with physics, people interacting with each other in a marketplace doesn’t always lead to clean models of their behavior and that is because men don’t always behave rationally when it comes to dealing with money.

Despite the axiom of rational choice in economics, people will often react emotionally to situations, giving in to impulsivity and poor financial decisions. Gaining some awareness of these anomalies will not only help you make better financial decisions over time, but will also help you recognize when it’s happening to others, allowing you to adjust your financial behavior to maximize the opportunity.

Hyperbolic Discounting

Given the choice between receiving $50 now versus $100 a year from now, most people will opt for the $50 now. Alternatively, when asked if they would like to receive $50 five years from now, versus $100 six years from now, most people will choose the $100 six years because it is the more economically rational choice.

The interesting aspect of this scenario is that both offerings involve a timespan of a year between the $50 and $100, and the $100 is the rational choice under both circumstances. In order to turn that $50 into $100 over the course of a year it would take an annual return of 100% and your chances of getting that high of a return out of any investment vehicle available is highly improbable. When offered an immediate gain of $50 we will often take it because it is more emotionally appealing to have $50 now than wait an entire year for the $100.

Denomination Effect

Priya Raghubir and Joydeep Srivastava conducted an experiment at an Omaha, Nebraska, gas station where they had people fill out a survey about their gas usage and gave them some variation of $5 – A $5 bill, five $1 bills, or five $1 coins. They kept track of who they gave what denominations to and when people went into the gas station’s convenience store they kept track of how much each person spent based on their various received denominations. The findings were that those with the five $1 coins spent the most, those with the five $1 bills spent the second most, and most people who received an individual $5 bill kept it.

Based on the results of the above experiment financially conscious individuals can increase their savings by simply carrying around bigger bills and making it a point to convert smaller bills into larger ones to help avoid the allure of spending them on goods that you otherwise wouldn’t have if you had larger bills.

The key to financial success is awareness – Whether it is awareness of how to balance a budget, knowledge of the stock market, or awareness of our own personal relationship with money. If you want to get ahead at this game then the best strategy is to focus on increasing your own individual awareness so you can keep and multiply as much of your money as you can.

Susan Porter is a financial expert who has passionately studied everything from value investing to decision making under uncertainty. Find more interesting financial information on the blog Stock Trading!

Comments (1)

  • The key to financial success is awareness – Whether it is awareness of how to balance a budget, knowledge of the stock market, or awareness of our own personal relationship with money.

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