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The Psychology of Money: How to Beat Your Brain When It Comes to Financial Decisions

Research shows that we all have "cognitive biases" (translation: mental barriers) that cloud our judgment, skew our perceptions and sometimes, ultimately, prevent us from making the best financial decisions.
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A couple days ago, a 20-percent coupon arrived in the mail from the kind marketers at Theory, the pricey fashion boutique I love to visit, but which has yet to convince me to spring for one of its crisp button-down shirts (they're $180 plus tax).

That is, until I got this tempting coupon code. I hopped onto the store's online shopping website this evening, determined to find something, anything, to buy. I strangely felt like it was my duty to shop. After all, how often does Theory offer a storewide discount? I convinced myself I would be missing out on a great opportunity, otherwise.

But the reality eventually set in. I don't need any new clothes, and definitely don't need anything from Theory. Sure, I might save $36 off the retail price, but I'd still spend $144. The thought of spending money on something I didn't need, or necessarily want, helped snap me out of my Theory coma. That, and realizing I had to write this piece on the psychology of money and how we make irrational financial decisions. Oh, and also, "The Office" came on and I got distracted. The one where they all try to make Dwight normal.

You might say that for a moment I became influenced by "myopic decision-making," a fancy term behavioral economists and psychologists use when describing our tendency to be narrow-sighted. It's totally silly, happens more than you think and is just one example of how the mind plays tricks on us, particularly when it comes to money. Research shows that we all have "cognitive biases" (translation: mental barriers) that cloud our judgment, skew our perceptions and sometimes, ultimately, prevent us from making the best financial decisions.

Napoleon Hill was onto something back during the Great Depression when he said that "both poverty and riches are the offspring of thought." When it comes to money, the brain does control the bottom line -- and in fascinating ways.

Here's a sampling:

Short-Term Memory

In an interview with Jay Ritter, the Cordell Professor of Finance at the University of Florida and an expert on behavioral finance, I learned that one of our greatest cognitive biases is that we tend to rely more on short-term patterns rather than long-term, which can be detrimental when making decisions that concern certain financial moves like investing in the stock market or buying real estate. "People tend to put too much weight on recent experiences," says Ritter. Just think about the latest housing bubble, he says, and how many of us were convinced real estate prices would never slow down.

I'm With -->

In addition to recency bias, another behavioral tendency that plagues us is "groupthink." Social psychologist Irving Janis coined the term in the 1970s. It's the notion that humans are prone to trusting conventional wisdom and the actions of crowds -- to a fault. Ritter offers up the recent housing implosion as an example of how groupthink can help lead to bad decision-making: "Many individuals believed, and were told by experts, that high returns were normal and should continue." We groupthought wrong.

If It Ain't Broke...

I'm guilty of this next barrier: status quo bias. "People tend to make decisions once and unless there's a strong reason to change things, that's where they tend to remain," says Ritter. "Credit card companies, cable companies, cell phone companies -- they all depend on this lethargy that you'll go years without changing what you signed up for."

Size Matters

We tend to measure things in small relative parameters, according to Dan Ariely, a professor of behavioral economics at Duke University and author of the best-selling book "Predictably Irrational." This bias can muddy our perspective on whether something is really worth it. In his book, Ariely uses the example that we may have no problem spending $3,000 to upgrade to leather seating on a car we're buying for $25,000. It seems like a small amount to spend, relative to the $25,000. What's another 10 percent, right? But funny enough, we hesitate to spend that same $3,000 on a new sofa, despite the fact that it may offer more utility.

Fast and Furious

People are more likely to make irrational purchasing decisions when they're either in a hurry or feel pressured. That's why infomercials make so much money. Consumer Reports recently published a study concluding that there's a science behind infomercials that helps set off our brain waves to make us feel compelled to buy. In fact, infomercials are perfectly written and produced to excite the dopamine levels (aka happiness levels) in the brain. After the loud and insisting commercials end, our dopamine levels typically drop within five to six minutes, but of course, we're encouraged to buy now... and, often, we do. Infomercials are a $150 billion industry.

Ritter says it's hard for individuals to make money decisions because we're not trained to think about things like mortgages, car loans and investments on a daily basis. These topics are largely foreign until we are forced to deal with them. But what about spending? We certainly do that on a day-to-day basis, but still many times -- as in my Theory episode -- we act without really thinking about the consequences. It's a matter of people putting more weight on current gratification than thinking about the future." As humans, we emotionally prefer to live in the now and deal with tomorrow when it arrives.

So are we being irrational, or just human?

Surely the two are different... right?


Farnoosh Torabi is the author of the new book "Psych Yourself Rich: Get the Mindset and Discipline You Need to Build Your Financial Life" (FT Press, October 2010). Learn more about Farnoosh and her work at Farnoosh.TV