How to Use Logical Thinking to Build Your Money Sense
Most of us have experienced financial stress at some point in our lives. It can be a cause of great anxiety and even depression. Money problems can also lead to relationship difficulties and family conflict.
It’s essential that we develop our money sense—the ability to think logically about money matters. This will help us make sound financial decisions, avoid financial pitfalls, and build a bright future for ourselves and our families.
Lessons Set in Dollars
The Guinness Book of World Records listed Marilyn vos Savant as the person with the highest recorded IQ. Marilyn has been writing the “Ask Marilyn” column since 1986 for Parade, the Sunday magazine for over 340 newspapers nationwide. In the column, she addresses questions ranging from health and social science to economics, psychology, and even math.
One reader asked Marilyn this question.
The following problem has been with me since childhood, so far without an answer: Three people went to a hotel and rented a room for $30, each paying $10 for his share.
Later, the clerk discovered the room price was only $25. He handed the bellman five $1 bills and asked him to return them to the three people.
The bellman, not knowing how to divide five dollars among three people, gave each person one dollar and the rest to charity.
Here’s the question: The three people originally paid $10 each, but each received $1 back, so they’ve now paid $27 for the room. Add to that the $2 that the bellman gave away, and you have a total expenditure of $29 instead of $30. What happened to the other dollar?
Before learning the answer, try solving the question yourself. The answer concerns a logical fallacy that often clouds us from making the right financial decision.
Here’s Marilyn’s answer:
There’s no missing dollar. The total expenditure is now only $27, accounted for by adding the $25 for the hotel clerk to the $2 for charity.
In other words, the original $30 is now divided like this: the hotel clerk has $25, the guests have $3, and charity has $2.
The error arose when an asset ($2) was added to an expense instead of the other asset ($25), thereby mixing “apples and oranges,” giving us fruit salad instead of a correct answer.
As Marilyn points out in her book, The Power of Logical Thinking: Easy Lessons in the Art of Reasoning… and Hard Facts About Its Absence in Our Lives, we constantly (and illogically) jump back and forth between different aspects of the same fact. For example, when interest rates go up, we’re happy to see our savings grow, but stressed to find it unaffordable to take out a loan for a new home.
There are many ways to develop our money sense. One is to learn to recognize logical fallacies—errors in reasoning that can lead us to make poor financial decisions.
Common Logical Fallacies Concerning Money
The gambler’s fallacy is the belief that you are more likely to win your next bet, if you have lost money on a bet. This logical fallacy can lead to ruinous losses, ignoring the fact that each bet is an independent event.
Investors often study trends to predict the market. When there’s a winning streak, they worry about an upcoming downturn and cash out early. In a losing streak, the same investors hold on to poorly performed stocks, believing a break must be drawing near.
The key takeaway is that you should never invest based on trends alone, positive or negative. Study each stock of interest to understand its business value and growth potential instead.
Another logical fallacy is the sunk cost fallacy. This is the belief that we should continue to invest in something as long as we have already invested a lot of money in it, even if it is no longer a good investment. This can lead us to hold on to those losing stocks for too long or to stick with a failing business venture.
Sunk cost fallacy leads to a phenomenon called Regret Avoidance. It’s a theory of investor behavior that analyzes why investors hold on to, or even add to, poorly performing investments, in the face of clear signs that they should sell.
Here’s an example: Some people like European cars for their power and speed. Because of high labor costs and many moving parts, maintenance can be costly over time. Say, you bought a nice car that requires constant repair. Adding up the cost of fixing various problems, you realize you’re spending more money than the original cost of your car. Would you sell the car and buy another more reliable brand? Most people will stick to their original choice, keeping up with the maintenance, instead of admitting the mistake and choosing wisely next time.
Recognizing these logical fallacies can help us avoid them and make better financial decisions.
Mental Accounting Behaviors
We all want to make rational decisions regarding money, but emotions keep getting in the way. One example is Mental Accounting Behaviors.
In this scenario (taken from Daniel Kahneman’s Thinking, Fast and Slow), “you aim to catch a show at the local theater, and tickets are $20 each. When you get there, you realize you’ve lost a $20 bill. Do you buy a $20 ticket for the show anyway? Behavior finance has found that roughly 88% of people in this situation would do so. Now, let’s say you paid for the $20 ticket in advance. When you arrive at the door, you realize your ticket is at home. Would you pay $20 to purchase another? Only 40% of respondents would buy another. Notice, however, that in both scenarios, you’re out $40: different scenarios, the same amount of money, different mental compartments.”
Developing Money Sense
Besides recognizing logical fallacies, there are other ways to develop our money sense. One is to learn about the basic principles of personal finance. This includes learning about budgeting, saving, investing, and credit. Many books and websites cover these topics extensively. This article focuses on the basics of logical thinking and money sense.
Keeping a Spending Journal
Another way to develop our money sense is to keep a spending journal. This helps build awareness of our spending patterns and makes it easier to identify and implement changes. Mint and Acorns are two popular apps that can help you achieve your goal. Interested in learning more, this article shows you the five best apps to keep track of your expenditure and secure your financial future.
Saving for Rainy Days
Do you know how much you really need to save for retirement? An important aspect of money sense is to see where you are and what you can change to stay on track for the future.
This Merrill Personal Retirement Calculator lets you view a projection of your savings to see if there is a gap between what you’ll have and what you’ll need when you finally retire and helps you adjust your strategy accordingly.
With the calculator, you can see how potential adjustments to your savings goal, retirement date, and investment choices can affect the size of your retirement savings in the future.
The difference 1% can make
A small change in savings could give you substantially more after 30 years.
Strategies to Lower Financial Risks
There are many investment websites that focus on this topic. Here are just a few examples of lowering risks in a volatile market.
Dollar Cost Averaging
Dollar cost averaging is a strategy that can help you lower the amount you pay for investments and minimize risk. Instead of purchasing shares at a single price point, with dollar cost averaging, you buy in smaller amounts at regular intervals, regardless of price.
Investopedia explains Dollar Cost Averaging as this: Suppose you determine that the value of your investment will rise by $500 each quarter as you make additional investments. In the first investment period, you would invest $500, say at $10 per share. In the next period, you determine that the value of your investment will rise to $1,000. If the current price is $12.50 per share, your original position is worth $625 (50 shares times $12.50), which only requires you to invest $375 to put the value of your investment at $1,000. Follow this process until you reach the end value of your portfolio. This way, you have invested less when the price has risen, and the opposite would be true if the price had fallen.
Buying an Index
Because it’s difficult for average investors to outperform the market, you can lower your investment risks by buying an index. These market value-weighted indexes reflect the market’s collective opinion of each stock’s relative value. Buying an index allows investors to invest a small portion of stocks in a market index, such as S&P 500, mutual funds, and exchange-traded funds.
In The Psychology of Money, Morgan Housel wrote: By simply investing in the S&P 500 index over a 20-year period, we could generate a return of 8% to 11% with dividends reinvested.
The S&P 500 increased 119-fold in the 50 years ending 2018. All you had to do was sit back and let your money compound. But, of course, successful investing looks easy when you’re not the one doing it.
Since 1928, the S&P 500 has declined by 10% or more 91 times. 20% declines have occurred 22 times. It has fallen over 30% once every decade, with over 40% decline once every few decades. The key to investing is to let your money compound over time, weathering through market growth cycles.
Learning from Others
Finally, it is important to seek trustworthy sources of financial advice. There are many books, websites, and articles that can provide helpful information. It is also a good idea to speak with a financial advisor if you have specific questions.
Developing our money sense is essential to our financial well-being. Logical thinking can help us make better decisions about our money. Monitoring our own financial situation and analyzing spending patterns can help us develop a solid plan for the financial future.