Researchers have concluded that no matter how much education and experience we have, we are all equally likely to make similar mistakes. We fail to consider the real value of money, succumb to emotion, and seek quick rewards.
Such problems and mistakes leading to the loss of money are also commonly referred to as cognitive distortions. Here are a few examples:
- On payday you see a large amount on the card and think that now you can buy everything. Because of this a lot of money is spent on nonsense, and by the end of the month you have to save money;
- You agree to get less for your work, but right now, than to wait a while for more pay;
- You feel sorry for the money for a big purchase, but you easily spend on many small ones.
If you have experienced something like this, I encourage you to read this article.
What is cognitive distortion?
In scientific writings, cognitive distortions refer to systematic errors in thinking or pattern deviations that arise from dysfunctional beliefs embedded in cognitive schemes, or when people are used to thinking automatically, on autopilot. The existence of most cognitive distortions has been described by scientists, and many have been proven in psychological experiments.
Cognitive distortions are examples of evolutionary behavior. Some of them serve an adaptive function, as they facilitate more efficient actions or faster decision-making. Others appear to stem from a lack of appropriate thinking skills or from inappropriate application of skills that were adaptive in other contexts.
The development and application of methods to correct cognitive distortions that cause problems of an emotional, personal, and social nature is the subject of various strands of psychotherapy, particularly cognitive psychotherapy.
How do cognitive distortions affect our money?
Very much so. And the problem becomes larger because we often make purchases, investments, actions quite unconsciously, on autopilot.
1. We fall prey to the illusion of money
We forget that our ability to buy something does not only depend on the number in our account, but also on the fluctuations of prices. If you have gotten a raise, it doesn’t mean that you are any richer. After all, inflation has caused the price of goods to rise as well. That is the money illusion.
We don’t consider the real value of money. It seems to us that it’s always worth the same, but its value is constantly changing. For the same amount of money at different times, we can buy different amounts of goods.
This phenomenon was first discussed in 1928. Economist Irving Fisher described it as “the failure to understand that the value of the dollar or any other unit of money goes up and down”. It even affects our satisfaction with our position.
In 1997, behavioral psychologists confirmed this in experiments. They described the following situation to the participants: there are two people, they have the same education, position, and starting salary. The difference is how much they got a raise in their second year and the inflation rate where they live:
- First: salary 3,000, inflation 0%, increase 2%;
- Second: salary 3,000, inflation 4%, increase 5%.
Three groups of participants were asked to answer one of the questions: whose position is economically more advantageous, which of these people is happier, and whose position is more attractive. In terms of real income, the position of the First is more advantageous. After deducting inflation, his salary is higher than the Second’s. Most of them answered this way, when asked about economic benefit.
But when asked about happiness, they answered differently – they said they were happier than the Second. This is how the money illusion plays out. People think that a higher raise means more money, and therefore more happiness. It also makes them think that Second’s position is more attractive.
This proves that we are still capable of taking into account the real value of money when we are reminded of inflation. But under normal circumstances we forget about it and judge money incorrectly. We think we have more of it than we really do, and we make rash purchases.
How do you deal with it?
When making financial decisions, try to think rationally. Don’t give in to emotions. Remind yourself of inflation and the real value of money.
So that you don’t blow your entire salary at the beginning of the month, start budgeting. Calculate how much you spend on food, utilities, medicine and entertainment. Plan the rest of your purchases based on what you have left over.
2. We are influenced by hyperbolic depreciation
Suppose you were offered $3,000 today or $6,000 a year from now. Most people would then choose 3,000 immediately. We would prefer the award that we can get sooner. Even if it is less than the one that awaits us later. The future reward is not that important to us, we devalue it.
But if you put the question a little differently: $3,000 in nine years or $6,000 in 10 years, people are more likely to lean toward the second option. When it’s still a long time to wait for a reward, we think more rationally and choose a larger amount. But to make the right choice in the short term is more difficult for us.
This phenomenon explains credit card debt very well. Financial stability in the future doesn’t seem as valuable as the ability to buy something nice right now.
This cognitive distortion affects not only finances, but everything related to self-control. Addictions, eating habits, areas where you have to give up immediate gratification for the sake of future well-being.
For example, you are overweight. You realize that you need to move more and balance your diet in order to lose weight. You swear to yourself not to give in to temptation for the sake of future health. But then you can’t resist chocolate cake for dessert. Why? Compared to the immediate pleasure of cake, health in the distant future seems less valuable.
Some scientists explain it through evolution. When your distant ancestor saw a small, skinny antelope, he tried to catch and eat it, rather than wait for a bigger prey. Because he might not live to see it. As a result, the brain developed a mechanism that encourages immediate reward.
How do you deal with it?
Protect yourself from temptation in advance. To avoid spending on momentary pleasures, set a spending limit on your card. Automate your savings. Report to someone about your spending.
Before you make a decision, imagine yourself in the future: would the “future you” approve of such a choice. That way you will assess the facts more objectively.
3. We are subjects of the denomination effect
It often happens that we are afraid to spend on a large purchase, but not on many small ones. The denomination effect, or the effect of the value of banknotes, is to blame. Large bills seem more valuable to us, and we feel sorry to change them. We think of them as “real” money. Smaller denominations and coins, on the other hand, are not as valuable to us, and they are easy to part with.
You’ve probably felt the same way, holding a $100 bill in your hand. You don’t want to spend it. But the same amount of $5, $10, and $20 bills you mentally put in the category of everyday expenses and quickly spend it away.
Scientists described this effect in 2009 through a series of experiments. In one, they asked people to take a short survey and rewarded them with five dollars. Some with a single bill, and others with five one-dollar bills. The participants could then go into a store and spend what they received. Then the researchers asked to see their checks. It turned out that the people who received the five-dollar bill mostly refrained from spending.
This effect affects all people, but is particularly strong in countries where cash is a common payment method. Researchers described an experiment in China. 20% of Chinese women decided not to spend the 100 yuan bill they received (quite a lot at the time of the experiment). But among those who were given the same amount of money in small bills, only 9.3% abstained from shopping.
The denomination effect has another manifestation. A purchase seems more profitable to us if the price is not stated in one sum, but distributed by days or months. We find it easier to pay “$10 a day” for a service than “$3,650 for a year”.
How do you deal with it?
If you want to save money, do not carry a lot of small money. It is psychologically more difficult to part with a large bill, even if we know that we will get change from it. Use it as a defense mechanism against unnecessary spending.
Remind yourself that in the end, the change you spend adds up to a larger sum. To be clear, make a financial diary where you note your expenses.