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Why Money Makes People Crazy

Why Money Makes People Crazy

You don't need to know much about financial planning to have enough cash to be happy

It was the kind of thing a Brit might refer to as "bad form." This past May, Sarah Ferguson, the Duchess of York, was nabbed on videotape reportedly promising access to her ex-husband, Prince exchange for £500,000 (about $750,000). The person she was dealing with turned out to be an undercover reporter running a sting operation. Why would Fergie—a former British Royal, Weight Watchers pitchwoman, and bestselling children's book author—risk her reputation as well as her seemingly cordial relationship with her ex?

The fact is, money—just like love, drugs, and alcohol—can make us do crazy (and often stupid) things. And the more moola that's on the line, the more likely it is for logic to fly out the window. "No doubt about it, we act differently when money is involved," says Sheena Iyengar, a professor at Columbia Business School, who offers this explanation: "Money isn't just a tool we use to get the things we want in life." Sure, it may have started out that way, in the days when we traded in pelts or cowrie shells. But today money is loaded with all sorts of meanings: power, security, and again, love. And as a result, we treat money differently from other commodities.

"If I take any other resource—such as a basic one like water, or a luxury like bottles of champagne—and I say I'm going to divvy it up among my employees, there's a feeling that it should be split fairly," says Iyengar. "But if I say I have some extra money, more infighting is involved. People consider, Who's more worthy? Who's less? It's a value judgment—morality is associated with it. So it's much more complicated."

That's why clear thinking is of paramount importance in matters of how we spend, save, and invest. By following the advice on these pages, you'll improve your chances of managing your money rationally, even when your brain wants it the other way around.

Understand Your Natural Tendencies

Where money is concerned, people tend to do two things over and over, says Barry Schwartz, author of The Paradox of Choice. First, we adapt to how much money we have. That's why two paychecks after getting a raise you can't remember how you could have lived on less. Second, we compare ourselves with others. How much you have isn't nearly as important as whether or not you have more than your best friend or coworker does, says Schwartz, adding, "Chances are, if you make an irrational decision about money, one or both of those factors are in play."

Making or losing money can also cause the brain to go haywire. "Losing a lot of money is particularly painful," says Jason Zweig, author of Your Money & Your Brain. In fact, most of us hate parting with money much more than we enjoy gaining an equal amount. The phenomenon, called loss aversion, was first recognized by two psychologists from the Hebrew University of Jerusalem in 1979.

Here's what's going on inside your head when dealing with a financial loss. Fear and anxiety cause a part of the brain—the amygdala—to spring into action and prompt you to react. This "act now!" impulse can cause you to make snap decisions. Most people are wired to avoid loss, so this reaction often makes us bad investors, because we tend to unload our winning stocks and hold on to the losers. Why? Because, says Zweig, admitting the loss hurts too much.

Figure Out Your Risk Threshold

While most people are risk averse, some actually enjoy sticking out their neck, says Bert Whitehead, author of Why Smart People Do Stupid Things with Money. In the latter case, the hormones produced under stressful situations give them a high, and they enjoy the euphoric feeling so much, they can't resist seeking out risky situations (gambling, cheating on their spouse, buying hot stocks that are getting a lot of play in the news, jumping out of an airplane). When people have a high risk tolerance, explains Whitehead, they may have a skewed sense of what's truly dangerous and what's not. "I have clients who believe the stock market is risky, but they think nothing of going to Las Vegas and putting $10,000 down on the craps table." It's the gambling aspect that excites them.

To understand what you're doing, take a look at your behavior in other areas of your life.

Whether you get a jolt from playing extreme sports or having unprotected sex, you should know that the same risky patterns could be hurting you financially. But being too cautious isn't beneficial either. If you shy away from even small risks—say, trying a new food or traveling abroad—you may not be taking enough chances with your retirement portfolio. Loading up on CDs when you should have some stocks for equity isn't smart either.

If you want to make wise investment decisions, start by considering the appropriate asset allocations for your age. The rule: Subtract your age from 100. That's roughly the percentage of money you want to have in stocks. (For example, a 40-year-old should have 60 percent of her portfolio devoted to stocks.) Put the rest in bonds and cash. Then, if you want to take a chance and pour money into a friend's business or buy a stock you heard about on a tip, limit your exposure to just 5 to 10 percent of your portfolio. Super-risky bets (like casino gambling) should come out of your entertainment budget.

Consider the Trade-offs

Next time you're faced with a financial what-if, consider the alternatives. Most people don't.

Duke University professor Dan Ariely, Ph.D., author of The Upside of Irrationality, and his team of researchers went to a car dealership and asked shoppers, "What will you not be able to afford if you buy this car today?" Turns out, most were unable to answer. "Money is hard to think about. And when people have mortgages, loans, and credit cards—all of which make it more difficult to figure out how much money we have and how much we'll need—it's even trickier to decide whether or not to proceed," he says.

Making intelligent choices means being uberrational. Before pulling out the plastic, look at the best-case and worst-case scenarios. Ask yourself, If I make this purchase, what does the optimum outcome look like, and what's the likelihood that it will happen? Do the same for the worst possible consequence, and force yourself to look at what you would need to do if it occurred. "The trade-offs have to be made salient," says Iyengar. "They can't just be numbers. You have to understand them emotionally too." Translation: You can't just think about losing $1,000; you have to consider what it means to your life. Are you betting or spending so much that you'd have to give up dining out? Put off buying new clothes for a year? Move into a smaller apartment? Be as clear as possible about the consequences and it can help you make sound decisions.

Recognize the Allure of Living Large

Further complicating the scenario: The bigger the numbers get, the less rational we're likely to be. Take the lottery. When the jackpot is "only" a few million, people buy one or two tickets, or don't play. But when the prize grows to hundreds of millions, people will go to extremes to get in on the action, driving across the state line, even though the chances of winning have gone down. Fergie, who reportedly admitted after the incident that her finances were suffering, likely behaved as she did because of the large amount of money on the table and the fact that she had adapted to a lavish lifestyle. She didn't just want some money, she probably wanted enough to reclaim her former way of living.

But everyone who desperately longs to be wealthy should consider this:

A Roper study conducted for my book The Ten Commandments of Financial Happiness revealed that what you need to feel happy is enough cash to live comfortably—not lavishly, just comfortably. More money than that won't buy more happiness. Understand this, says Whitehead, and you can quite possibly control your brain and avoid nutty behavior. "The true definition of financial independence," he says, "is knowing how much is enough."

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