Why we use our emotions instead of reason when dealing with our money

January 26, 2008

I found this article extremely interesting.

Would you rather earn $50,000 a year while other people make $25,000, or would you rather earn $100,000 a year while other people get $250,000? Assume for the moment that prices of goods and services will stay the same.

My first impulse was to pick the first choice. My reasoning was that I would rather be financially better than others than the other way around.

Unfortunately, that was the irrational decision. Given that prices of goods and services are the same, why would I rather have half my potential income, just to be financially better than others?

Turns out that the majority of people also selected the first option. Not only that, but there are researches that attribute this behaviour on our genetics. The article mentioned explains it in details, which I won’t go.

Another example I liked was the “ultimatum game”. If your partner are given $100 to split between him and yourself. Whatever division of the money he proposes you, if you accept it, you each get to keep your share. But if you reject it, neither of you get any money.

Rationally speaking, any money offered you would be free. So a $90-$10 would be better than anything, since you’re still getting out with $10.

Interestingly, research shows that proposals that offer much less than $70-$30 were rejected because they were “unfair”.

Again, the article goes in detail explaining why this is so common.

What I think is important for us to know, is that we are inclined to use our emotions rather than reason when deciding what to do with our money and that is something we need to be aware of.

That is also probably one of the main reasons for our current sub prime mess. People buying homes (they couldn’t afford) because of peer pressure or because they “loved” the house.

Never make big impulsive financial decisions. Always sleep on it. Don’t buy the house you “loved it” on spot. Don’t sign time-share contracts or any other contract on spot. Especially if you go to those large presentations that offer free tickets or free meal. They always try to use the latest sales tactics and play on your emotions rather than reason. You’ll often hear arguments like:

Don’t you think your family deserves this?
Don’t you love your family enough to get them this?
Are you willing to risk your family’s future?

Don’t do whatever your financial advisors tells you to do before checking the details and sleeping on it. Don’t buy life insurance before learning about the differences. Always, always sleep on it.

Be aware that we’re genetically wired and predisposed to waste money and you save yourself from getting in a huge financially mess.