Financial Literacy

Money. Most of us spend a good portion of our lives pursuing it - whether directly through our careers or indirectly through investments, side jobs, or entrepreneurial ventures. So, money plays a significant role in almost everyone's life - in fact, a lack of it often leads to stress and anxiety, and some studies have even shown that financial stress lowers your IQ.

Yet, while money plays a significant role in our lives, we rarely stop to examine our fundamental beliefs about it. How often do we question the unconscious biases that shape our spending, saving, and investing decisions? And if we did, what would it change?

Money and Psychology

One of the most striking findings in social psychology is the effect of "money primes" on human behavior. In a notable study led by psychologist Kathleen Vohs at the University of Minnesota, participants who were subtly reminded of money (for example, by seeing images of currency or word puzzles involving money) demonstrated shifts in behavior. They worked harder on tasks and showed greater self-reliance but became less helpful toward others. This finding is consistent with other research suggesting that overemphasizing material gain can correlate with lower satisfaction with interpersonal relationships.

What does this all mean for you and me? Even a subtle reminder of money can trigger significant behavioral changes. Now imagine how powerful our entrenched, long-held beliefs about money must be. If we unknowingly carry biases - such as "more money equals more happiness" or "money is the root of all evil" - these attitudes can directly influence how we approach everything from daily spending decisions to major life choices like buying a home or negotiating a raise.

The Limitations of Behavioral Economics

This week's theme on the psychology of money pulls heavily from research in behavioral economics - a field that uses psychology to understand people's relationships with money. It is also important to note that psychology in general has been undergoing what many call a "replication crisis," where some famous studies have not been replicated as robustly as initially hoped. While the broad takeaway - that money holds potent sway over human thought and behavior - remains widely accepted, it's always wise to consider these topics with a grain of salt.

The bottom line, however, is that money can alter attitudes, motivations, and interpersonal behaviors - it's the degree of impact that's debatable. Ongoing research continues to refine our understanding of why this effect is so strong.

How Beliefs and Biases Form

Our financial beliefs often form in childhood and are influenced by our families, communities, and broader cultural messages. If you grew up in a household that experienced scarcity, you might develop a "scarcity mindset," feeling you must hoard resources. Alternatively, if you grew up with parents who spent freely, you might adopt a more cavalier stance toward credit card debt and saving for the future.

These formative experiences don't just vanish when we become adults; they transform into unconscious scripts that guide us. For example:

• Belief: "Spending money on myself is selfish."
• Potential Outcome: You may neglect self-care or professional development, limiting long-term opportunities.
• Belief: "Only flashy items show success."
• Potential Outcome: You might funnel money into conspicuous consumption, hampering your ability to invest in retirement.

Remember, your past experiences don't determine your current beliefs with absolute certainty, but it's fair to say they do play an important role. And sometimes that role can be oppositional, leading to behaviors that are the opposite of what you experienced (for example, if your parents were always in debt, you may want to avoid debt altogether).

Common Biases at Play

As we'll learn, several well-studied cognitive biases come into play in money matters:

• Confirmation Bias - Seeking out information that aligns with existing beliefs, such as reading only articles that confirm your suspicion that "stocks are too risky," can lead to missed investment opportunities.
• Availability Heuristic - Overestimating the importance of recent or dramatic events - like a market crash - could cause panic selling, even when history shows markets often rebound over time.
• Loss Aversion - We feel the pain of losses more acutely than the pleasure of equivalent gains, potentially leading to overly cautious investing or refusing to sell losing assets when it might be best to cut our losses.

We'll explore these and other topics in this week's theme.

Why It Matters

If a fleeting reminder of money can alter our willingness to help someone or childhood experiences can guide life-long attitudes about our financial lives, it's clear that these entrenched (and potentially misguided) beliefs have the potential to shape the trajectory of our entire financial life. We may even risk making costly mistakes - like racking up high-interest debt or passing up investment opportunities - simply because our internal "money scripts" lead us astray.

By examining and, if necessary, challenging our beliefs, we gain a critical measure of financial self-awareness into why we may make certain financial decisions. Money may be powerful, but our willingness to question our assumptions can keep it from dictating choices that ultimately conflict with our goals and values.

Let's get started!

Mistakes are part of being human. As the English poet Alexander Pope famously said, "To err is human, to forgive, divine." However, when it comes to money, lenders and creditors typically don't share Pope's generous stance.

Financial mistakes can haunt us for years, perpetuating stress and sometimes leading to long-term hardships like damaged credit or insufficient retirement savings.

Why do people make choices that work against overall financial health? How can we guard against them? Let's explore common pitfalls and the cognitive traps that could lead us astray - and how to avoid them.

Common Financial Errors

Focusing on the Short-Term

Prioritizing the present over the future is one of the most common (and potentially harmful) financial traps many of us experience. For example, anytime there is a significant downturn in the stock market, we can see the adverse effects of short-term thinking in action. Panicked investors often rush to sell in fear and miss out on the gains when the market rebounds - an emotional choice versus a rational decision.

It's certainly true that those approaching retirement, for example, may wisely sell in a downturn to reduce risk and preserve capital. But for long-term investing, history shows us that even after severe market corrections (like the dot.com bubble or the crash at the start of the Covid pandemic), the market typically regains the loss within a few years. Past performance doesn't guarantee future results, of course, but the trend is clear.

Lifestyle Inflation

Earning more money is often a double-edged sword. If you spend more every time you get a raise - nicer car, more expensive hobbies - you might end up with the same net savings as before. Lifestyle inflation is a subtle trap because it usually happens gradually.

Much like short-term thinking, this kind of lifestyle inflation is common. The result can be a significant shortfall in long-term goals, whether homeownership or retirement.

No Emergency Fund

Living paycheck to paycheck leaves us vulnerable to unexpected events like a medical emergency, a job loss, or a major car repair. According to recent Federal Reserve data, many Americans would struggle to cover even a $400 emergency expense without going into debt. An emergency fund is an essential cushion that can turn a crisis into a manageable inconvenience, but for many, the best time to get started is always another day.

Neglecting to Budget

Budgets are the guardrails of our financial lives. Yet many of us bypass them because they can feel restrictive or tedious. Without a budget, it's easy to lose track of daily expenses - making it more challenging to work towards other goals (like saving or reducing debt). A budget not only provides structure but also offers a sense of control over money.

Why We Make These Errors

Part of the reason we repeat the same mistakes lies in our psychological wiring. Behavioral economists have identified biases like loss aversion, where the fear of losing money overshadows logical risk assessment, and present bias, which causes us to prioritize immediate gratification at the expense of future well-being. If we don't actively work to counterbalance these biases, they can sabotage even the best financial intentions.

Emotional triggers - such as stress from a demanding job, fear spurred by alarming economic news, or envy fueled by social comparisons - can override rational planning. Without awareness and coping strategies, we become reactive rather than proactive.

Strategies to Avoid Financial Mistakes

• Set Concrete, Measurable Goals - It's easier to stay the course when you know exactly what you aim for. Rather than vaguely saying, "I want to save more money," set a goal like, "I will save $5,000 in an emergency fund over the next 12 months."
• Automate Good Habits - Consider direct deposit or automatic transfers to savings and investment accounts. By automating contributions, you reduce the temptation to spend money impulsively and help your future self avoid the pitfalls of forgetfulness or changing moods.
• Pause Before Major Decisions - If a big purchase or financial move feels urgent - like selling stocks after a downturn - build in a mandatory cooling-off period. Sometimes a 24-hour (or week-long) pause is enough to break an emotional cycle and let rational thinking resurface.
• Track Your Spending - You can't manage what you don't measure. Whether you use a spreadsheet, a budgeting app, or pen and paper, understanding your spending patterns is crucial. This awareness often reveals areas where you can cut back and funnel more toward savings or debt repayment.
• Seek Professional or Peer Support - Whether from a certified financial planner or a community of like-minded savers, a neutral viewpoint can help you see around your blind spots. Encouragement and accountability from others can also reinforce good habits.

The Takeaway

We're all capable of making poor financial decisions, and we'll likely never entirely avoid them. The secret is to learn from each misstep.

Identifying the psychological underpinnings of our mistakes is half the battle. The other half is using strategies that help us resist emotional impulses and destructive biases, giving us the best chance at lasting financial well-being.

When we fail to make a good decision about how to save or spend money, we often cast it in moral terms. We fault ourselves for not sacrificing enough, or for not having the willpower to resist our financial temptations.

Yet there's much more going on beneath the surface. Good money management isn't simply about trying harder, or overcoming our shortcomings. In fact, in many ways we're programmed to fail. Human beings are riddled with powerful cognitive biases that can easily undermine and thwart our best intentions. While we might be cognizant of the financial mistakes we're making, and feel determined to make changes, these biases are often so deeply ingrained that they prove extremely difficult to overcome.

Here's the truly troubling part - sometimes we aren't even aware our biases exist. This is one reason why so many people are confounded by the fact that they never seem to get anywhere, despite their best efforts to spend and save more efficiently.

With that in mind, let's review some of the most common cognitive biases that afflict us - and what we can do to mitigate their effects.

Anchoring Bias

Humans have a strong tendency to privilege the first bit of information they receive when making a decision. This effect, known as anchoring bias, can play a decisive role in negotiations, financial management, and day-to-day decision-making.

One of the problems with the anchoring effect is that if the first bit of information is faulty (as is often the case), then all subsequent decisions are suspect. One example: The initial price a salesperson asks for a car anchors the rest of the negotiation. Offers that are lower than this initial price seem like bargains - even if they are still higher than the car's actual value. 

Falling victim to anchoring bias may result in spending more money than necessary, or accepting a suboptimal negotiated deal, such as the aforementioned car sale or a salary offer.

Endowment Effect

Sometimes also referred to as the "ownership effect," this bias is responsible for our privileged feelings toward objects we already own. Research studies have shown the effect of this bias in action, showing that people will pay more to keep items they already possess rather than pay for something of equal value they don't own. 

Studies have also shown the mere act of touching an item can instill feelings of ownership. Combined with the endowment effect, that's a recipe for significant overpayment.

The Sunk Cost Fallacy

Nobody likes to take a loss. In fact, sometimes we're so desperate to avoid that scenario that we ultimately end up doing far greater damage than we would have by simply cutting our losses.

If you've ever heard the phrase "throwing good money after bad" then you're familiar with the negative effects of ignoring sunk costs.

Present Bias

Have you ever bought a bunch of bananas only to throw most of them out after they've turned brown? Or signed up for an expensive gym membership that you rarely use? Then you're familiar with the effects of present bias.

Humans tend to believe that our wants and desires remain largely static, yet that's not true. We also love to procrastinate. Unfortunately for us, the longer we wait, the more expensive things tend to be.

Planning Fallacy

Somewhat similar to procrastination, planning bias describes our tendency to underestimate grossly how long certain tasks will take, or how much effort will be required.

According to the Center for Retirement Research at Boston College, roughly half of Americans have no retirement savings - a problem that can be partially blamed on the powerful effects of the planning fallacy.

The Takeaway

Cognitive biases are responsible for some of our worst financial decisions - yet many people aren't even aware they exist. By being conscious of their power, you can mitigate their effects while minimizing irrational financial decision-making.

The great writer Flannery O'Connor once remarked, "Free will does not mean one will, but many wills conflicting in one man."

And that's true - we are a collection of warring impulses, all jockeying for prime position. This observation is especially true when it comes to how we view money. Consumer society seems to measure success in dollar bills - but we're also told that money is no guarantee of happiness.

We all want to be financially secure. Unfortunately, too many of us are failing in that regard. Total American credit card debt topped $1 trillion in 2023 - an average of $5,733 per cardholder. Further, studies have shown that half of Americans couldn't come up with $2,000 in the event of an emergency, not to mention a projected retirement savings shortfall for most Americans.

Clearly, we understand the importance of intelligent financial decisions. Unfortunately, we're often failing to put our good intentions into practice.

Much of this can be traced to our conflicted psychological relationship with money. Intellectually, we know that we're supposed to save. We know that we're supposed to budget and avoid unnecessary expenses. Interestingly, another set of impulses within us is working to counteract our best-laid plans.

These are the same impulses that tell us to privilege today over tomorrow. We rationalize wasting thousands of dollars on luxury items. Or, ignore the bills we can't pay because "maybe they will just disappear." These are the beliefs and biases that undermine us. There's good news, however - through setting financial goals and creating a plan for achieving them, we can minimize the influence of these beliefs.

Looking for ideas? Here are a few to consider:

• If you have difficulty putting good intentions into practice, consider breaking down your goals into smaller pieces. Give yourself a few things that can be accomplished quickly and easily. Poor financial decision-making is a pattern; you need to break that pattern by creating a new one.

• Even the savviest financial person has to contend with cognitive biases. It is essential to cultivate awareness of these biases and work toward mitigating them.

• Set realistic goals. Aim for too much, too soon, and you'll likely get discouraged. It's also important to think about what you want. Money is just a means to an end. How can it help you achieve satisfaction and happiness?

• Keep a meticulous budget and write your goals down on paper. Make these things tangible. Your brain privileges ideas that are expressed on paper.

• Think about your future self in an empathetic fashion. It may sound rather abstract, but studies have shown that people who have done this (via an age-progressed photo) are more likely to make sound long-term financial decisions.

The Takeaway

When it comes to reaching financial goals, we're often our own worst enemy. By recognizing this fact, we can take steps to "outsmart our programming" and let the impulse toward sound financial decision-making come out on top.

We all have a complex relationship with money -- it's a subject that touches just about every facet of our lives. The lack of money is one of the chief causes of divorce and relationship stress. Financial problems can undermine our performance at work and eat away at our physical and mental well-being.

With stakes like those, it's no wonder people often think and act irrationally when finances are involved.

It's important to realize, however, that complex doesn't necessarily mean unhealthy. If your fundamental, underlying attitudes and beliefs about money are sound, the chances are good that your financial outcomes will be favorable. On the other hand, if cognitive biases and irrational thinking dominate your beliefs about money, trouble is likely to follow.

Challenge of The Week: "How Do I Feel About Money?"

This week, we encourage you to take a few minutes to do something most people never will: rigorously examine your underlying thoughts and beliefs about money. This writing exercise will help you define how you truly feel about money, thereby shining some light on the sometimes mysterious motives that guide our behavior.

Pen and paper work best for this exercise.  A recent Princeton University study showed that students who wrote things down on paper learned more effectively than those who typed notes on laptops.

Once you're ready to begin, consider answering the following questions:

• Do I believe money will make me happy?
• Have I become happier as I've become wealthier?
• How does money influence my perception of self-worth?
• Do I make rational decisions where money is concerned?
• Do I repeat the same financial mistakes over and over?
• Are my financial decisions governed by emotion or reason?

Once you've explored these questions and any others you find relevant, consider how your beliefs about money have influenced your behavior, for better or worse. The goal is a thorough, relentlessly honest self-appraisal. By doing this, you can potentially uncover faulty assumptions and mistaken beliefs that have been hampering your ability to make rational financial decisions.