One thing that always stood out to me about economics is the existence of this mythical creature, a perfectly rational, all-knowing narrowly self-interested human being called homo-economic. It is this idea that this being can always make the most effective decisions possible to maximize his profits. Most classical economic models are based on this creature but is this the best approach?
You and I both know that this person is being doesn’t exist in the real world. You are human. After all, you’re not always rational you experience emotions and feelings. You don’t always have the information readily available to you. And even if you do, you might not always make the best choices because, again, you’re human. And I think with money and finance, too many people forget this fact that you’re not perfect, and that you, and everyone else are guilty of these six money traps every single day. But that doesn’t give you an excuse to not strive to improve yourself when you can.
Listen, Financial Education and Economics. They’re both boring, especially with the overly complicated theories and formulas that can make anyone fall asleep in a matter of minutes.
Here’s how to know if you are financially sensible
Do me a favor and think of your mental bandwidth or cognitive ability as three empty squares. Each square represents something that you can focus on at any given time. When something big happens like you’re worried that a bill is coming due, a square gets filled up, limiting your ability to focus on other things.
Financial IQ test
As each square gets filled, you become more prone to the scarcity mindset, which reduces your overall cognitive ability to solve problems or retain information which makes you more impulsive and more prone to making poor financial decisions. A research study conducted by Princeton psychologist Eldar Shafir found something very interesting. He gathered a group of students and asked them to complete several IQ tests while thinking about different financial scenarios.
Scenario A was imagining you’re driving a car and then it needed a simple car fix that would cost around $150. To change parts to improve car ability was a much more financially demanding task, which would cost $1,500. Which would be 10 times more.
What the results show
Then he sorted the participants by household income and found it very fascinating how those who were in the middle class and above did well in both scenarios, their IQ scores. On the other hand, those who were considered poor performed very differently. This poor group did well with scenario relatively small one in the dollar face. But in Scenario B, your IQ score has dropped significantly.
Why do the poor have lower IQ
The researchers found that people who have some sort of emotional or financial constraints tend to score lower on the IQ test, due to cognitive limitations, or the three squares being filled. The scarcity mindset can lead to anxiety and showed you to make decisions that can further negatively impact your finances.
A scarcity mindset destroys your financial mindset
People with a scarcity mindset tend to take on payday loans much more often than others and pay the loans. By the way, these super high-interest loans might seem like a good solution in the short term. It will cause you to owe a tonne of money in the future because of the high-interest rate. But don’t worry, you can change this mindset by doing this one simple thing!
Create safety nets for yourself
It’s giving yourself a break. Now you can increase the number of squares that you have. You can cut out things that are taking up mental space. Small things like setting up automatic payments and reminders are a really good start. Creating a standard routine is just stopping pointless activities.
Build an emergency fund
Start building up your emergency fund and free up your mental load just a bit. So you don’t need to constantly obsess over the last page. But of course, it’s easier said than done when you don’t have much money to start with. Not all of us have a bunch of extra cash or time just laying around. Those who are in poverty may find it challenging. But that’s where fixing the next money mistake can help tremendously.
Understand opportunity cost
Everything you do in life, whether that’s eating a cheeseburger or watching a movie has a cost. And no I’m not talking about the actual cost of that activity. But is that a cost that you can’t see? I bet that you didn’t know that everything has a hidden price, called opportunity costs.
Sounds scary, right? Well, it is because not knowing these hidden costs is one of the biggest financial mistakes that people make without even knowing it. Here let me explain.
What that cheeseburger really cost
Let’s say that you have $6000 in your pocket. I deserve to treat myself and so you decided to buy the most expensive cheeseburger in the entire world for $6,000 Which, by the way, is ridiculous. You can get a nice Quarter Pounder with Cheese from McDonald’s, which is probably just as delicious.
The $6,000 is the cost of the cheeseburger, but the opportunity cost is what you could have done with those $6,000 Instead, you could have gone on vacation, invested in your business, or even bought a nice red brick, or whatever.
What opportunity is lost
I’m not here to judge. But what you do need to know is now that $6,000 is now gone. It’s no longer in your possession and all the other opportunities that that money could have been spent on no longer exists. Now here’s what would blow your mind. Think of it like this, that cheeseburger cost you $60,000 over 30 years that an average rate of return of 8% if you invested the money instead. So what’s that cheeseburger worth?
Getting caught in sunk cost fallacy
If you buy something and that cost has already happened, meaning that the transaction went through and the money is no longer recoverable. Then that cost shouldn’t influence any future decision.
What the heck? Okay, here’s an easy example.
Let’s say you just spent $10 to watch Shark data just because after 20 minutes into the movie, you start to question your entire existence and ask why anyone would spend $2 million to make this steaming pile of fun sharks. But instead of leaving the movie theatre, you think that you’ve already spent the $10. You might as well finish the rest of the movie, otherwise, you’d be wasting your money.
No, this is where the sunk cost fallacy grips. It’s a rational pause around our minds and makes sure that we get our money’s worth even though it shouldn’t matter anymore because the cost is not recoverable and you just be wasting more time and the opportunity cost of that time.
Are you in a sunk cost fallacy?
But it doesn’t just apply to these little things like a movie ticket. The sunk cost fallacy also applies to other areas such as your job, you’re sitting at your desk, you’re drinking all the free mediocre coffee you want. But then one day at work you feel empty. You feel like something inside is missing. You’re thinking that perhaps you made the wrong decision and that this job makes you miserable. You just say screw it and start from scratch somewhere else.
No, of course not. You probably say in your mind.
You’ve already invested years and years of your life into this current job. And you think that you’d waste all those years if you switch to something else. But the sunk cost fallacy is this invisible anchor that’s tied around your leg pulling you in deeper and deeper unless you actively untie it.
Again, it also goes with opportunity cost because there’s always that if you did stay an extra hour to finish watching the miserable Shark movie. What else could you have done with your time? Not understanding sunk cost can warp your perception of value, but that’s not the worst of it. The next mistake can leave you financially ruined forever
following the herd mentality
Transactional utility is a psychological trick that companies have been exploiting for centuries to lure you into wasting your precious dollars in the US.
They even have a whole day dedicated to exploiting you. Businesses like Amazon with their Amazon Prime or Alibaba’s Single day where huge discounts are given are actually meant to be used to exploit the masses.
Getting caught up in chasing “discounts”
Research shows that what you buy isn’t just dependent on the value of the well relative to its price, but it’s heavily impacted by your perception of a good deal.
If you believe that you’re saving some money when purchasing something, you’re much more likely to go and buy it. This is great when you get a deal for something that you already intended to buy. But it gets financially dangerous when the discount itself convinces you to buy things that you never originally wanted.
Let’s say you walk into your favorite supermarket. You just want to get some ingredients to make a delicious cheeseburger. No lettuce no tomato. But on your way to the cheese aisle. You see a huge red side advertising organic and tasty lettuce just like this one over here. That is 30% off. Wouldn’t you be tempted at least to check it out?
Heck, you might even buy it and forget while you’ve been going to the store in the first place. You go home feeling fantastic, awesome things that you just got to deal with lifetime aid saved you a good chunk of money, but in reality, didn’t need it.
Mental accounting is when people keep separate mental buckets of their money and then track their spending based on which bucket it’s coming from. Instead of treating all your money as one big pool, it is a bit confusing, so make sure you pay attention to this thing.
Why it isn’t good to be using mental accounting
The problem with mental accounting is you’ll overvalue or undervalue certain ones, People tend to categorize these things without much detail and then recklessly spend it on things like a $6,000 cheeseburger because they mentally assign a different value to it from their regular paychecks.
That’s why companies will have a tonne of tax refund sales and discounts from the end of January until really at the end of the day, the value of money is the same. Although mental accounting is better than nothing. It’s a mistake that will get worse if you let it go unchecked.
The most powerful skill: Delay Gratification
This all starts with marshmallows. What do the most significant money mistake that you’re making right now and a big predictor of your future? Well, in 1972, the first marshmallow experiment was conducted and became a staple in every college psychology course. researchers gathered a group of kids gave each of them a marshmallow and then gave them one of two options.
They can either eat the marshmallow now or if they wait a bit, then they get more marshmallows, and then the researchers left the room and watched history unfold. This test has revealed that the children who were able to delay their gratification or wait for more marshmallows were far more likely to be successful in their adult lives.
the power of delayed gratification
And the simple reason is this. They had the discipline to overcome their impulses for immediate pleasure. And instead, wait for it big reward in the future, which is one of the keys to financial success.
That’s delayed gratification and successfully reaping the long-term benefits instead of just focusing on the short-term rewards. Now don’t think for a second that just because I’m sharing these money mistakes with you that I don’t fall for them anymore. I’m not a perfectly rational human being and I make these mistakes. too. But I’m trying to improve every single day and hopefully after you learn from these mistakes, you can do the same.