Avoid Magical Thinking In Personal Finance And Make Better Plans

Avoid Magical Thinking In Personal Finance And Make Better Plans

Like most people, I like to daydream about a stage later in my life where all of my financial worries are taken care of and I can pretty much do anything I want with my time. I spend my days going on hiking trails, doing some volunteer work, writing a novel, doing a little bit of travel with my wife, visiting my children in college or in their adult lives, organising community events, playing lots of board games with friends, reading… things I’d love to be doing with my time in retirement. It’s a very joyful picture for me, but there’s one big problem with it. That daydream completely glosses over what I had to do to get there. It overlooks the many, many years of work and savings that it would take to achieve that goal. Without a ton of hard work, that wonderful vision is not a realistic outcome. It’s magical thinking.

Photo by Ersu (Flickr).

Trent Hamm is a personal finance writer at TheSimpleDollar.com.

So what exactly is magical thinking? I like Wikipedia’s explanation:

Magical thinking is the attribution of causal or synchronistic relationships between actions and events which seemingly cannot be justified by reason and observation. […] Magical thinking may lead people to believe that their thoughts by themselves can bring about effects in the world or that thinking something corresponds with doing it. It is a type of causal reasoning or causal fallacy that looks for meaningful relationships of grouped phenomena (coincidence) between acts and events.

One great example of magical thinking when it comes to money is in the realm of lottery tickets. People who regularly play the lottery vastly prefer to pick their own numbers, even though the outcome of the lottery is random. People even buy and sell books on this subject, books which amount to little more than pointing out the boundaries within which lottery numbers are drawn and then using a mix of bad maths and magical thinking to come up with useless “practices” for picking lottery numbers.

While that’s a fun example, magical thinking shows up all the time in people’s financial planning, causing them to make some enormous foolish mistakes.

For example, far more people believe that they will receive retirement benefits than there are people who actually have such benefits at work.

Magical thinking occurs in personal finance every time we overestimate the likelihood of a particular positive outcome far beyond what’s realistic in our current lives, and it becomes dangerous when we act based on that overestimation.

Examples of Magical Thinking and Money

Here are a few powerful examples of how people use “magical thinking” to make huge financial mistakes.

The Overly Optimistic “Future Self”

Many, many people fall into the financial trap of believing that their ‘future self’ will pay for their current financial mistakes. For example, many people at lower rungs on the employment ladder will spend more than their salary and rack up debts because they believe their “future self” — who will have risen up the employment ladder and be earning more money — will pay for these expenses.

Why not travel now if that magical ‘future self’ will foot the bill?

In our non-magical reality, while there is a chance that your future self will rise up the ladder and earn more, there’s also a good chance that your future self won’t rise at all or that your future self might become disillusioned and switch careers entirely.

If you make today’s financial plans based on a massively inflated likelihood of a bigger salary down the road, you’re falling prey to magical thinking. You have a very good chance of digging yourself a deep financial hole that will take you a very long time to dig out of if you don’t happen to hit that optimistic future.

The ‘Prosperity Gospel’

Many people tend to believe that if they look for direct intervention from a higher power, that the higher power will enter into their lives and create a better outcome for them.

This type of magical thinking underlines things like the prosperity gospel, which I described in an earlier article:

To put it simply, the prosperity gospel focuses on the idea that God provides material prosperity for those he favours. The idea goes both ways: materially successful people achieve such success because they’re favoured by God and, at the same time, people who are favoured by God will eventually be materially successful. In other words, godliness causes material prosperity.

This type of perspective turns one’s faith into a transaction-based system. If I act in a particular godly way (usually as prescribed by the person preaching the prosperity gospel), then God will reward me with material things.

While I think that prayer has many benefits, it, too, can follow similar logic. If I ask for divine intervention in this event, then there will be a greater likelihood of the outcome I desire from this event. Again, this makes faith into a transaction-based system.

The problem with faith as a transaction-based system is that it really doesn’t work that way. For example, charitable giving is highest among lower-income households and is lowest among wealthy households, which is exactly the opposite of what you would expect if the prosperity gospel were true.

I don’t know of any reasonable theology in which you can treat God as a personal ATM for the things that you want. Instead, prayer and charitable giving tend to have the best impact in terms of being tools to help you grow as a person internally, not as a source for physical rewards.

‘My Ship Will Come In’

Many people buy into the idea that some great unknown future event is going to solve all of their worldly problems. That vision takes a lot of different forms — the wealthy ancestor leaving behind some money is one flavour, winning the lottery is another flavour. I once worked with a person who basically thought that they would eventually be wronged in the workplace and could then sue the workplace for big bucks. That person claimed to document every possible slight and negative event in the workplace. (Needless to say, I did my absolute best to avoid workplace interactions with that person.)

The truth is that while random events do happen and bring unearned wealth into people’s lives, the likelihood of such events is incredibly small. There are very, very few life-changing lottery winners. There are very, very few real-world examples of massive unexpected inheritances. These things just don’t happen very often at all. People constantly overestimate their likelihood and people sometimes even plan their lives assuming such a thing will happen, which is a big part of the reason why a majority of Americans simply don’t save for retirement at all. They believe their ship will come in.

How to Avoid Magical Thinking and Make Better Plans

The overall picture is clear: magical thinking results in an unfounded optimism about the future and thus causes people to make poor choices today because of that unfounded optimism. While it’s fine to have positive visions about the future, it’s incredibly dangerous to take actions in your life under the assumption that those positive visions are a foregone conclusion.

How can you avoid magical thinking in your life? Here are five strategies that really help.

Strategy #1: Assume Unlikely Positive Events Have Zero Chance of Happening

If you find yourself daydreaming about your ‘ship coming in’ — you win the lottery or you get a big batch of cash from an unexpected source or something akin to that — never, ever assume that there is any likelihood of that happening. Treat the chances of that event happening as zero, even if the odds are better than zero.

Any time you start to treat a highly unlikely event as having greater odds of occurring than it actually has, you begin to make poor life choices. If you believe that a big bunch of cash is about to fall in your lap without any direct evidence of it and then you begin to spend accordingly, you’re digging yourself a hole that you’re unlikely to dig yourself out of.

Money is not going to fall out of the sky and land on your lap. Don’t behave as though such a thing is going to happen.

Strategy #2: Assume Your Future Self Is Going to Be Worse off Than You Are Right Now

In terms of making financial plans for the future, you should never assume that you’ll be earning more in the future. Instead, you should be assuming the opposite — you’ll be making less in the future.

Why on earth would you do that? If you operate under the assumption that your future self is going to earn less, you’re not going to willingly dig yourself into a financial hole that’s going to be difficult to dig out of. You’re not going to buy a car with huge payments. You’re not going to saddle yourself with a giant house payment. You’re going to avoid credit card debt.

Let’s say, then, that you do happen to earn more in the future. That’s great! Now you can actually afford that nicer stuff without digging a giant hole for yourself! Go for it!

However, most of the time you won’t end up earning a substantially larger amount in the future, and if you chose to go into debt now, your future self is going to be digging out of that debt in the future without any real additional income. In other words, your future life is going to be rather miserable, even if you maintain your current income.

If your income drops due to a job loss or something like that? It’s going to be very, very bad.

When you’re trying to decide whether to take on a debt or another big expense, ask yourself what happens if your salary stays unchanged for the next, say, ten years. Now, what happens if you lose your job and have to take one that pays 25% less. What does your life look like under those scenarios with that big debt weighing you down? If that’s going to make for a very miserable and very tight life, then don’t take on that debt today. Instead, run the other way.

Strategy #3: If You Want Something in Your Future, Take Action, and Accept That It Might Not Happen 

If you don’t work for something, it’s basically never going to be handed to you. Rewards aren’t just handed out for free. It’s a lesson that people theoretically should learn as children, but adults often act as though they should rewarded for just being there.

The truth is that if you want that promotion, you need to work for it. If you want a successful small business, you need to work for it. If you want a raise, you need to work for it. It’s not going to be handed to you. You have to show that the additional money you’re receiving is justified, or other people are going to justify NOT giving it to you.

You think you’re in line for a raise at work. Why? Are you doing something exceptional that makes you worth a higher rate of pay than other people doing your job? If you are, is it something that equates to results that your boss can actually see in some fashion? Is this something that is true consistently, day in and day out?

You think you’re in line for a promotion. Why? Are you doing something that demonstrates that you have the skills and communication abilities and leadership necessary to pull off the next rung on the ladder? If you think so, are you doing things that demonstrate those skills to your boss in a way that he or she can actually see? Are you doing that consistently?

You think you’re ready to get a better job. Why? Does your resume actually include all of the skills that employers are looking for in your position? Do you have extra things on there that supplement your case and really show off how you have all of those skills and can put them to work? Do you have solid references? Do you have current skills and some evidence of those skills? Are you selling those things to potential employers?

You think you’re ready to start a business. Why? What does your business plan look like? What evidence do you have that your business will click in the community it’s serving? Can you or will you put in the work needed to make this business a success?

What’s the common theme here? Hard work. Whenever you want to move up in life, it takes work. Even if you think it’s all about the people you know — and that’s something I don’t believe at all but I do believe it helps a little — it still takes a lot of effort to build a good professional network. If you want something, you have to work for it. It will never, ever be handed to you.

Strategy #4: Save for Retirement. If You’re Already Saving, Save More 

You can never be saving “enough” for retirement. Even if you somehow manage to reach a magic number that will cover everything you could ever want in retirement, more money simply means more security within retirement or the possibility of retiring earlier, both of which are positives.

If you ever believe that you’ll have plenty for retirement, the truth is that you do not. If you are ever thinking about whether you should be putting more into retirement savings, the answer is that you should (unless you’re overlooking high interest — anything above about 6% — debt).

Many people resist this for two reasons. One is pure magical thinking — their ship will come in before retirement so they won’t have to worry about it. That’s not going to happen.

The other is that they envision that they’re going to lose a lot of joy from their life if they increase their retirement savings by 1% or 2% of their salary. That’s not going to happen, either. The truth is that the things you lose from contributing more are the least important 1% or 2% of your spending. It’s the stupidest, most forgettable elements of your spending. It’s the item from the convenience store that you drink and forget about. It’s the album you bought from the iTunes store and listened to once and forgot about. It’s not the things that really matter.

When you combine magical thinking with an unrealistic fear about your lifestyle, it’s completely understandable why people talk themselves out of retirement savings. Don’t. Both elements are myths. You need to be saving as much as you realistically can.

Strategy #5: Build an Emergency Fund

This goes back to that rosy view of the future that many people hold. When most people think about their future, especially the near future, they tend to mostly think about the positives. Unless their car is rattling a lot, they don’t think about their car breaking down. They don’t think about losing their job (unless paranoia is rampant at work). They don’t think about a child being sick and the cost of emergency child care. They don’t think about losing their wallet or having their credit card number stolen.

The truth is that those things happen. Thinking about a near future where nothing like this happens is a flavour of magical thinking, and if you act in full accordance with that kind of magical thinking, you end up in a financially rough spot, facing down bills and (likely) credit card debts that you just won’t want to face at all.

The best solution for these situations is to have cash in hand in case something goes wrong. Cash is king. Cash solves problems that credit cards cannot. You want cash for the widest breadth of emergencies life can throw at you.

How do you ensure you always have some cash for emergencies? An emergency fund is the answer, of course. You can set one up by opening a savings account at a local bank and setting up an automatic transfer to move a little money once a week out of your checking account — just $10 or $20 will do if you’re tight. If you automatically transfer $20 a week, you’ll put more than $1000 a year into your emergency fund!

Never, ever turn off the automatic transfer unless a change in income absolutely forces you to do so. Even if there’s plenty in your emergency fund, ignore it. Wait until an emergency hits. You will be so glad you have that money.

Final Thoughts

Magical thinking is a huge financial trap. It causes you to ignore risks going forward. It causes you to avoid taking necessary financial steps to protect your future. It causes you to make giant spending mistakes in the here and now, ones that you’ll suffer the consequences of for many years.

Do all you can to drop the magical thinking and stick to reality. Your actual, real life will be far better off.

Good luck!

Personal Finance and Magical Thinking [The Simple Dollar]

This post originally appeared on The Simple Dollar.

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