The Psychology of Money

“Money’s the greatest intrinsic value – and this can’t be overstated – it is the ability to give you control over your time.”

Morgan Housel, Author of “The Psychology of Money” Book

Although there is no universally accepted scientific definition of the psychology of money, the concept is widely recognized and used not only in psychology but also in behavioral economics and finance. Actually, it is a psychological process during which we show our attitude and behavior towards money. In other words, psychology of money reflects the connection between our thoughts and financial actions. There may be different opinions on the basis of the clarification of this concept. And in fact, no one can prove that someone else's opinion is wrong.

According to Morgan Housel, the author of “The Psychology of Money” book, doing well with money has a little to do with how smart you are and a lot to do with how you behave. So, how you handle your money matters more than just how smart you are – financial success is not about intelligence but about behavior and psychology.

Some people may think that money is a financial asset and has to do more with math and science. In fact, they are not partially wrong, because indeed money is a highly valuable asset. But from a psychological perspective, money is influenced by many factors that are purely behavioral, not scientific.

Let’s look at some of the main aspects of psychology of money:

1. Emotional influences – Fear, greed, envy, guilt, shame, pride, regret, anxiety, hope and many other traits have a profound effect on the psychology of money. Fear of financial loss can lead to risk aversion and can sometimes prevent you from making necessary investments. On the other hand, greed can drive people to take risks which can sometimes lead to financial losses. Feeling of guilt and shame can cause avoidance or denial of financial problems based on past performance failures. As a result, people regret past financial decisions which will negatively affect to the current opportunities. Anxiety can cause stress, which can prevent you from having hope and taking positive actions for better financial outcomes.
2. Cognitive biases – Loss aversion, herd mentality, anchoring, recency, availability and overconfidence biases have huge influence on psychology of money. Loss aversion will cause people to prefer avoiding losses over making gains. Herd mentality is the tendency to follow the actions of a large group of people even regardless of rationality. This is risky especially in terms of financial investment decisions. In some situations, loss aversion can contribute to herd behavior as individuals may be influenced by the fear of missing out or the desire to avoid losses that others are experiencing. Anchoring bias is often associated with relying heavily on initial information or reference points, while overconfidence bias involves excessive confidence in personal knowledge and abilities.
3. Personality traits – These include risk tolerance, impulsivity, conscientiousness, financial attitude, etc. When it comes to people's attitudes toward financial risk, risk aversion and risk tolerance are at opposite ends of the spectrum. Impulsivity describes a tendency that involves acting on impulses or desires without thinking through the long-term effects which can lead to financial losses. This can be defined as lack of self-control, whereas conscientiousness entails responsibility and self-discipline in the pursuit of long-term objectives. Overall, personality traits can influence individuals’ attitudes toward money.
4. Social influences – Social norms, family, peer pressure, cultural values and similar things have their impact on psychology of money. Social norms, such as retirement savings and investment strategies, can shape financial decisions of individuals. Sometimes children's attitudes toward debt, investment preferences and saving habits can be influenced by their parents' financial behaviors and values. Financial decisions can be greatly impacted by peer influence, especially when it comes to spending patterns, investment choices and lifestyle preferences.
5. Financial decision-making processes – Information processing, judgment and choice behavior are among the cognitive and emotional processes underlying financial decision-making processes. Information processing involves gathering and analyzing financial information which helps to assess the potential risks and rewards of different financial choices and make judgments based on personal beliefs, past experiences, cognitive biases and emotional reactions to financial risks and uncertainties. When making choices, people take into account a number of variables, such as their financial objectives, risk tolerance, time horizon, and some constraints like budget constraints or legal requirements.

Another best quote by Morgan Housel is worth remembering:

“Your personal experiences with money make up maybe 0.00000001% of what’s happened in the world, but maybe 80% of how you think the world works.”

So, clarify your financial habits and always remember that success in money is all about behavior!

Prepared by: Seda Janazyan, Business Analyst at CFOnline.co