Friday, August 28, 2015

Applied Psychology series (3/4): Psychology of Money

A brief sketch:
I have drawn upon various academic work & scientific research, from an Applied Science perspective. My objective, was to provide practical tips which can find application in our real life.
In the interest of keeping the blog-post concise, I had traded off the details of the research work & have focused on the key aspects. However, at the end of the blog, I have listed down the references for advanced readings.
Flow of topics, are as follows:
# Definition (Psychology of Money
# Concept of Money
# Conventional Economics to Behavioral Economics
# Psychology of Money:
1. How we perceive Market & Social norms
2. Money as motivator
3. Money & it's relation to Happiness
4. Anticipation of money
5. Our behavior in relation to Soft Money
6. Mental accounting
7. Money Illusion
8. Availability Heuristic
9. Loss aversion

Psychology of Money! When I had heard this phrase for the first time it really caught my imagination. So what does it mean? Let us take the two key words: Psychology & Money as separate entities & then try to connect the dots.

What is Psychology?

In layman's term it is defined as 'study of mind', but directly studying mind (mental processes) is difficult, because mind is abstract & non-tangible. However, the mental processes (i.e. thoughts, motives, attitudes etc) has an outward expression through one's actions, emotions, behavior & habit.

Thus in true sense, Psychology is both an applied & academic field that scientifically studies (observes) the outward expression of mental processes & seeks to understand & explain thoughts, emotions & behavior.

What is Psychology of Money?

It is our beliefs, feelings, behavior & habits around financial matters & their influences on our money management (e.g. choices we make, spending, purchasing, savings, investments, altruism etc).

Concept of money:

I had reached out to my friends, requesting them to respond to a survey question: 'What is their definition of money?'

The essence of their responses were:
  • Money is an instrument for carrying out transaction (for buying necessities)
  • Money is our means (tool) for achieving our ends (needs/goals)
  • Money should always be in circulation for it to remain valuable.
This shows, we all perceive an intrinsic value in money, we perceive money as a means for meeting our needs & wants, we perceive money as a means for gaining social status & money in circulation keeps our economy (market) running.

Money has become such an integral part of our life, that we seldom give a second thought about the origin of these mental concepts.

If we take a biographical approach of money, we would see that the concept of money had an evolutionary journey, hand in gloves along with human beings.
Artistic expression depicting the evolutionary journey of money
Barter (direct exchange of commodity).....Token money (shells, stones, grains, salt etc)......Coins (metals like Gold, Silver etc)......Paper money (originating in ancient China)......Plastic money (Debit & Credit cards)........Digital money (Net banking)........Mobile money (mobile wallets, Apps etc) future the concept of money may continue to evolve to suit our changing lifestyle.

Different forms of Money
To put things into perspective, Money is one of the greatest invention of human beings.

The invention of money is:
  • Conceptual (it is a figment of collective imagination which has an endorsement of the issuing authority - ancient times it was the kings & queens, while today it is Governments)
  • Tool for Facilitation (barter system was self-limiting & couldn't be scaled up; whereas money facilitated exchange of commodities & contributed towards expansion of market)
  • Dynamic (it's form changes - physical money to today's digital money)
  • Omnipresent (transcends into every aspects of our life - birth to death).
Like in the case of any important inventions (e.g. electric bulbs), the invention of money has changed our lives & our world forever.

Shift from Conventional Economics to Behavioral Economics:

In the book 'Coined' , the author Kabir Sehgal satirically mentions:
Association of ringing of bell & food provides motivation to the laboratory animal (dog) in Pavlov's experiment. Metaphorically speaking, Money has become our Pavlov's bell, activating our brain regions & conditioning our behavior wanting for more.

Even, if we discount the above satire as an exaggeration, won't we be dishonest to ourselves if we pretend ignorance to the influence of money on our thoughts, feelings, emotions, actions & behavior?

Foundation of conventional economics is build on the principle that human beings are rational & are able to trade-off between choices. However, in reality we humans are far from being 100% rational beings (logical), in fact our emotions, beliefs & habits have a strong influence on how we deal with money.

The research of Daniel Kahneman & Arnos Tversky (Nobel laureate in Economics, 2002) has shown how we have cognitive biases in our financial dealings & their pioneering work, has established Behavioral Economics, as a new way for understanding economics.

Contemporary research in Behavioral Economics & Neurosciences shows our dealing with money tends towards being more psychological, than an economic (logical) approach.

Let's explore the specifics of Psychology of Money

1. How we perceive Market & Social norms      

The underlying norms of social & market norms
Human society has two aspects - social (family, friends, acquaintances) & market domains (business & professional) & the unsaid norms of the concept of money, for both the domains are very different from one another. Our relationship with money, lies on a continuum between market norms & social norms. Gift economy operates in social world & Money operates in market (business) world.

  • Generally, in social domain direct exchange of money is not recommendable. (Though offering of direct money is economically more efficient, but the anticipated social value gets eroded. Direct money does not help in nurturing the relationship & doesn't build social capital).
  • Culture specific social norms dictates, when money is regarded as an appropriate gift.
  • The price & the type of gift determines it's appropriateness. (culture & context specific). The price of a gift which is too less or too expensive, can end up being perceived repulsive. Also, a gift which does not sync into the context, occasion & right culture fit will end up hurting the receiver.
  • Advertising the cost of gift, violates the social norm.
  • There is a thin line between gifts & seeking favour in business world.
  • In social world, people are willing to work (help) for free. If money is introduced to procure help, then the willingness to work (offer help) is drastically reduced. The willingness to work, goes up once again, only if large amount of money is offered). 
  • Social relationship creates a greater sense of reciprocity, in comparison to business relationship. (depending on what kind of relationship one wants to build, he can mix & match gift economy & direct money).
  • Once, one moves away from market norms to social norms, it is difficult to go back to the market norms in the same relationship.
Lessons for us: 

As we live on a continuum between market norms & social norms, we can judiciously mix & match, direct money & gift economy. This will help us in enhancing our social capital, help us in nurturing our professional & personal relationships.

2. Money as motivator

Money as motivator

The word motivation means, a force that creates stimulus & drives us towards achieving it. For long, it is believed that money is the most powerful motivator, for us to go to work. The mathematical equation is as follows: Money = Motivation, Motivation = Work & Work = Money.

It is true, that Money has a big motivation effect on us, but 'Money to be considered as the best motivator', is debatable.

Let's look into some of the key aspects of money's influence on human psyche:
  • In most of the cases when asked, people say they aspire for 'freedom' (they define freedom as having enough money, so that they can pursue things they really want to do). It indicates, that the real motivation is the end result i.e. 'the state of financial freedom' & not just money.   
  • Societal relativity, rich & poor, have's & have not's, social hierarchy etc has become ingrained in our psyche. People strive to become better than one another on this perceived relativity scale. It indicates, that the real motivation is social recognition & money serves as a tool for achieving this outcome.
  • Several research at work place has indicated money does not serve as the best motivational tool. Money is shown to encourage self-serving short-term behavior better than it motivates lasting institutional achievement. Over-reliance on monetary rewards erodes emotional commitment. [Some of the long-lasting motivational factors at work place are: Empowerment (to feel autonomous), Personal time, Happiness, Recognition, Goodwill, Emotional bonding (feel related to others), Challenge & New Learning (feel competent)].
  • Money as incentive tool - For tasks requiring cognitive ability, low to moderate performance based incentives can help. But when incentive level is very high or clubbed with penalty clauses, this leads to undesirable stress, distraction & ultimately leads to reduction in performance level. 
Lessons for us: 
  • One should develop the ability to distinguish the means (money & how money is earned) & the ends (financial goal & life's purpose). This clarity & self-awareness will increase one's well-being & help them stay focused on their life's journey. 
  • Ideal situation would be when one is aware of their life's vision/purpose & while working towards achieving them, income of money happens as a by-product
  • An employer (organization) can create a healthier work environment by including the psychological competent along with money as a motivational tool. The resulting engagement will be deep rooted & long-lasting in nature.

3. Money & it's relation to Happiness

Maslow's hierarchy of needs

Abraham Maslow's 'Hierarchy of Needs', depicts the needs of human beings in the order of priority.

The more one steps up on the pyramid, the human needs transforms itself from biological needs, to materialistic needs & into psychological needs.

Money & Happiness, the law of diminishing returns

When the basic biological & materialistic needs are not met, it results in unhappiness.

With increase in income & fulfillment of these basic needs, results in exponential gain in the happiness level.

However, once these basic needs & a decent comfort level in life is achieved, further increase in income level (money) does not result in similar gains in the happiness level.

This phenomenon is called the law of diminishing returns (i.e. marginal increase in the output, in spite of pumping in input).

Lessons for us: 

This indicates more money may not be the key to long-term happiness. Once the basic needs & a decent comfort level is achieved, one needs to engage themselves into activities which gives them a purpose & meaning, for experiencing gain & maintaining their happiness.

4. Anticipation of money

In anticipation
I am risking myself to sound like a geek :). Studies in the field of Neurosciences shows how various brain regions responds in relation to money. 

Nucleus Accumbens (part of the reward & punishment system of the brain) activates when anticipating a gain, while Anterior Insula (part of cerebral cortex & functionally linked to emotions) activates at the prospect of loss of money. 

The anticipation of making money leads to a surge in Nucleus Accumbens & increases Dopamine levels.

Surprisingly, Nucleus Accumbens fires less intensely, when one received an award, in comparison to anticipation of money. This indicates, that idea of gaining money is a stronger neural stimulant than money itself.

  • Since anticipation of money acts as a major force in our mind, this probably throws some light on why many people involve in gambling & purchasing of lottery, even though the probability of winning is very minimal. 
  • One needs to be aware that in the domain of consumerism, many marketers are exploiting this aspect by leading the potential buyers into anticipatory offers like lucky draws, contests etc, in their marketing strategy. 
  • As the prospects of losing money triggers negative emotions, many people tend to take a conservative approach in their investment decisions rather than opting for optimal portfolio. 
Lessons for us: 

With knowledge & awareness of how emotions are linked to money matters, one can become more conscious when placed in anticipatory situations & try to make rational financial decisions, taking into account the probability factors & weighing the risk benefit ratio.

5. Our behavior in relation to Soft Money

Hard Money (paper notes, coins etc) & Soft Money [Plastic money (credit & credit cards), Digital money (mobile wallets, mobile apps)]

Hard money & Soft Money

The world in which you & I live has technology, internet, consumerism, digital marketing etc as part of it's system. Going by the trend, the future is going to be driven by IoT (Internet of Things), Mobile Apps, Smart phones, Online shopping, Cashless transactions (soft money). There is going to be further sophistication of market intelligence, consumerism, big data (data mining & data analytics), enhancement of M2M (machine to machine learning) & artificial intelligence.

We humans do not have a long history of coping & living side by side, with such rapid advancement of technology & a cashless world (soft money), so there is could be high degree of variability in our behavior towards Soft Money when compared to Hard Money (coins, paper note).

Let's look into the key differences of our psyche & behavior towards Soft Money:

  • Payments by cash & cheque generates more pain of paying (registers in our memory more), in comparison to plastic money (credit/debit card payment).
  • Plastic money, results in underestimation of the past spending & increases the propensity for spending more in the current transaction.
  • In cashless transaction, we are unable to visualise, money being spend at the time of purchase. Whereas cash payment evokes thoughts of cost/benefits of purchase at the time of purchase. 
  • Psychographic reasons: Our behavior & attitude towards the usage & acceptability of plastic money (credit cards) differ due to psychographic reasons. Affective attides involve emotional feelings (e.g. my credit card makes me feel happy); cognitive attitudes involves thoughts (e.g. heavy usage of credit cards results in heavy debt); while behavioral attitudes involve actions (e.g. I use my credit card frequently)
  • Temptation & Instant gratification: Some people may buy through credit cards, for a genuine reason (convenience of cashless transaction, emergency/unavoidable need). But on the other hand, many people end up buying through credit card, before their income arrives, as they succumb to their temptation & their urge for instant gratification.
  • Ignoring the interest rate & late payment clause: Consumers may not even consider the fine prints (interest rate & late payment clause) while making purchases with their plastic money. The reason being, they do not intent to borrow for an extended period when they make purchases. However, they may change their minds when the bill arrives.
  • Soft money makes us more gullible towards spending: With data analytics & market intelligence in practice, we unknowing are being succumbed to make purchases. With online, mobile app, digital wallet the convenience of payment has gone up significantly. Also as elaborated in the above points, the pain of payment is relatively low, which makes us more gullible towards spending our soft money.
  • Cultural influences on the usage of plastic money: 
a. Religion: Islam has a different point of view concerning credit cards, Though banks want consumers to use plastic money, they also have an obligation to abide with the Sharin (Islamic Laws). According to the Sharia, credit cards is permissible as long as one does not delay paying the bills & pays the total amount on time. Whereas in several other Islamic countries the usage of credit card is forbidden. [Taking this cultural aspect into account, the Standard Chartered Bank had launched a global Islamic banking brand 'Saadiq' in Mid East (Pakistan Standard Chartered, 2007).

b. Country specific cultural norms: The culture & traditional beliefs has a big influence in the way we view plastic money (credit cards). For example, country like USA is saturated with credit cards, on the other hand the credit card penetration is quite low in several other countries. China with 1.3 billion people, has only 67 million credit card users. The reason can be attributed to traditional of Chinese culture, i.e. Chinese tend to save more & are reluctant to take on debts. Another example is Germany with 82 million population, the credit card holder are only 10 million people. This phenomenon can be traced back to German tradition & culture, wherein Debt (Schuld in German) means guilt.

Lessons for us:
Now that we understand the evolution of money (hard to soft) & we understand we are living in this time point where a major transition in the concept of money is happening, we can become more conscious towards our behavior & adaption in relation to this changing form of money.

As our feelings, emotions & cognition are very different towards soft money, we need to raise our level of self-awareness to distinguish between our Needs & Wants. We also need to make the right choices & make the right judgment between the convenience of the mode of payment VS. staying on course with our financial budget/goals.

6. Mental accounting (categorisation of money)

Mental accounting of money
We all have a tendency of separating our money into seperate category (accounts) in our mind.
This categorisation is based on variety of subjective criteria, like the source of money, intent for each category. This is almost like how an organisation does financial planning & budgeting exercise (each department are allocated their respective fixed budget). Similarly, in our minds we do mental accounting for our money e.g. household budget, entertainment budget etc.

Mental accounting can lead to the following behavioral outcomes:

  • Compartmentalizing income & assigning it into different mental accounts violates one of the basic rules of economics - i.e. money is fungible (interchangeable).
  • The source of money, influences how we spent it.
  • The setting up of mental accounts, can have paradoxical effects.[To illustrate this point, let us think of an office scenario. At the end of the financial year, one might not get approval for a new laptop because the IT hardware budget has been exhausted, but he might be granted an overseas trip because there is money left in the travel budget. One's rational argument that the need for a new laptop is more critical for smooth functioning of work, is most likely to fall on deaf ears.This phenomenon can translate in personal finance management as well, for example one might end up compromising in one particular dimension of life's need (e.g. fuel budget), because the budget assigned to this particular category got exhausted, but he might end up lavishly spending on another dimension of his life (e.g. entertainment). Basically, he ends up treating his money as non-fungible & does not reassign it].
  • Mental accounting can lead to snap deals on items we may not need. When something sells for below the assigned mental price, the deal takes precedence over the actual utility of the item.(For example, according to the dimension of one's living room, a person would have decided to buy a three seater couch. He assigned a mental budget (price) of Rs. 5,000 for his purchase. When he visits the furniture store, he finds an ongoing sale in which a five seater couch is put on sale at the same price (Rs. 5,000). Even though the three-seater couch was meeting his utility needs, he mostly might opt for the five seater couch (mismatch with his utility, need & does not fit in well with the room dimension). The occurs because, the price matches his mental price & this takes precedence over the utility).
  • Mental accounting & treating money as non-fungible can lead to misplaced priorities & not spending money wisely. (One might not spend money on utility, because he would have exhausted the budget assigned to it in his mind) but end up wastefully spending money on outing/entertainment, without diverting the fund to meet his utility bills).
Lessons for us: 

The alternative to mental accounting is to think about our money in a complete rational manner, i.e. each time to evaluate the opportunity cost & benefit across all categories.
But in real world, being 100% rational all the time is next to impossible. Even though the concept of Mental Accounting is not a full proof method, it is probably a useful tool for our money management.
With the awareness of the fallacies of mental accounting, we can improve upon it by being more self-conscious & treating money as fungible across all category. This will enhance our effectiveness in money management & make mental accounting methodology work more in our favour.

7. Money Illusion

Money Illusion

Have you observed a child, 4 or 5 years of age? If you offer then five coins of Rupee One denomination, they would feel happier, than receiving one coin of Rupee Five denomination. This is because they look at the absolute value i.e. five coins vs one coin, even though the monetary value is same. This is a type of money illusion, which plays in a child's mind.

The not so good news is, we adults too are not free from money illusion. By our natural instinct, we ignore factors like inflation & deflation while making financial decisions. That is, we think of money in it's nominal value rather than real monetary value (which tends to decline on a time scale due to inflation).

Lessons for us: 

Due to money illusion, we tend to discard the erosion of our wealth (purchasing power) in the future. This short sighted approach & being ignorant of the real monetary value, can hit us hard if we ignore saving for our retirement days (inflation will erode the purchasing power of today's money). Hence, we should make ourselves self-aware of money illusion & start our financial planning for a secured retired life, in our not so distant future. 

8. Availability Heuristic 

Availability heuristic

Availability heuristic is one of the limitation of our cognitive ability. We tend to make financial decision based on the readily available information & based on what we recollect (remember), rather than exploring & examining all the other possible alternatives. In simple words, it can be described as 'taking short-cuts' rather than going through the lengthy & cumbersome process of detailed evaluation.  

Lessons for us: 

In most of the cases, any financial decision which is made on limited information (readily available) skipping through a detailed evaluation & analysis can lead to regret in future (in hindsight we do pick up our errors). 
Also, due to the tendency of availability heuristic, we are gullible to get persuaded by a seller & end up purchasing something which may out-run it's value & utility in the long run.
Hence, with the awareness of 'availability heuristic' phenomenon, we should consciously delay our decision making time (avoid snap deal or start exploration much early) & in this extended horizon of time period we can try to explore more options, seek information & reach out for diverse point of views, before making the final decision. This can help us in making a better financial decision, which has more probability of withstanding the test of time.

9. Loss aversion

Loss aversion
It appears, we humans are hard-wired towards loss aversion. In economics, loss aversion refers to our strong tendency towards avoiding losses towards acquiring gains. Studies have shown, the negative feelings coming from loss are much stronger than the positive feelings coming from gain.

The tendency of loss aversion, influences our money management in the following manner:

  • Making a decision of changing the investment portfolio, seems very difficult, because with the change there is a probability of 'what if my decision goes wrong?' The thought of incurring loss makes us uncomfortable, whereas maintaining status quo seems a convenient route, overriding the obvious not so favourable, opportunity cost.
  • We end up holding on to things for a longer period in time, even though we know it is not making good financial sense. Example, holding on to a poorly performing stock for a long period in time, hoping that it will revive & we will avoid making loss.  
Lessons for us: 

With the awareness of our strong emotions towards loss aversion, we can make conscious effort in separating our emotions from our financial decision process. By overcoming our negative emotions towards loss aversion, we can increase our probability of better money management.

Psychology of money is a two way traffic, our mind is on money & money is on our mind.

Psychology of money, it's a two way traffic

From time immemorial, money has been part of human civilization & when something becomes as natural as breathing & sleeping & eating, we seldom take a step back to reflect, introspect & question our relationship with that phenomenon. May be something similar has happened to us & to our relationship with money.

We should remind ourselves that money was an invention of humans & it was invented to serve as a tool to facilitate transaction for meeting our needs. 

Money was a means to meet our ends (goals) & it was & is not to be confused as an end in itself. 

Like everything else, with passage of time, with evolution & systems moving from being simple to complex, our understanding towards money has got blurred. 

Also, money being a long term companion of humans, in the course of it's journey, it has learned to exert it's influence on our minds. 

By understanding the 'Psychology of Money', we can get valuable insights & we can go beyond the obvious, thereby making our relationship with money & money management more effective & healthier. 

Hopefully, this understanding can help us in making our life richer, not just in monetary sense but in it's true sense of richness.

(in alphabetical order)
  • Behavioral Finance: Key concepts - Mental Accounting (
  • Cashless Society & Plastic Money Marketing Essay (
  • Coined - Kabir Sehgal (a very interesting book, which takes a biographical approach towards money)
  • Predictably Irrational - Dan Ariely (highly recommended for readers interested in Behavioral Economics)
  • Study of Factors Affecting Use of Plastic Money (
  • Washington Post (Mental Accounting)

(in alphabetical order)

Special thanks to my friends Protyush Lala, Preetha Ajit & Nandhini Thangavelu, for their thoughtfulness & participation in the 'Survey Questionnaire'.

Sincere thanks to my seniors Bhavesh Acharya, Raghavendra Kalmadi & Sanjay Patel, who have helped me to see money in a new perspective.

Images taken from internet search, no copyright violation intended.