Chapter 14 - You will change Flashcards
Summary
Chapter 14 of “The Psychology of Money” emphasizes the reality of human change over time and the profound impact it has on our financial and life decisions. We often tend to underestimate our capacity for change, falling prey to the “End of History Illusion,” where we believe that the person we are now is the final version of ourselves. This illusion can distort our perception of long-term financial planning, causing us to make decisions based on who we are at the moment rather than factoring in the likelihood of our future self evolving.
A significant example shared by the author is of his friend who aspired to be a doctor but later regretted his choice as the demanding nature of the profession took away his joy of life. Similarly, a high-earning individual may choose to quit their job for a better work-life balance, significantly affecting their ability to continue with their initial savings plan.
The chapter underscores the importance of moderation in financial planning. The allure of both simplicity and luxury can wear off with time as we adapt to our circumstances. Therefore, it’s important to strike a balance in financial decisions, avoiding extreme ends.
Finally, the author advises acknowledging the inevitability of change and avoiding anchoring decisions on sunk costs. The faster we can adapt to change, the sooner we can return to the beneficial process of compounding.
Plan
Plan:
Acknowledge the reality of change: Embrace the fact that your future self is likely to be different from your present self, with varying wants and needs.
Practice moderation: Avoid the extremes of either frugality or extravagance. Find a balanced financial strategy that suits your current needs and future expectations.
Factor in future change in financial planning: Consider your capacity to change when planning for the long term. Be flexible and adaptable in your approach.
Avoid reliance on sunk costs: Don’t make future decisions based on past efforts that can’t be recovered. Learn to let go and move on quickly.
Q: What is the “End of History Illusion” in the context of financial planning?
A: It is the belief that we have changed significantly until now but will not change much in the future. This illusion can distort our perception of long-term financial planning, causing us to make decisions based on who we are currently, without accounting for the possibility of future change.
Q: Why is balance important in financial planning?
A: Balance is important because the allure of both simplicity and luxury can wear off as we adapt to new circumstances. Striking a balance in our financial decisions helps us maintain our satisfaction and interest over time, allowing us to stick to our long-term financial goals more consistently.
Q: How can acknowledging the inevitability of change benefit our financial planning?
A: Acknowledging the inevitability of change plays a crucial role in our financial planning as it allows us to adapt to new circumstances and to revise our plans as per the changing situations.
For example, imagine a woman named Lisa who, at the age of 25, lands a high-paying corporate job. Based on her current lifestyle and income, she sets a financial plan focusing heavily on savings and investments, with the goal of retiring by 50. However, over the next decade, Lisa realizes that her passion lies in social work, and she desires to transition to a lower-paying job in this field.
If Lisa was stuck in the ‘End of History Illusion’ and rigidly adhered to her initial financial plan, this career shift might cause significant financial stress, as it would drastically reduce her savings rate.
However, by accepting change as an inevitable part of life, Lisa would have been able to design a flexible financial plan from the beginning. This could include:
Diversifying her Investments: Instead of putting all her money in high-risk, high-return assets, Lisa could diversify across various asset classes (stocks, bonds, real estate etc.) to balance risk and return.
Building an Emergency Fund: Setting aside money for unexpected life events or changes would provide Lisa a safety net when transitioning to a lower-income job.
Investing in Skills/Education: Lisa could allocate resources to continually learn and develop new skills, providing her with greater career flexibility.
Adjusting her Lifestyle: Instead of living at the edge of her income, Lisa could maintain a lifestyle that allows for saving and investing, even if her income decreases.
By incorporating this flexibility, Lisa can comfortably make her desired career switch, readjust her financial strategies, and maintain her financial health without significantly impacting her retirement plans. Thus, accepting change and planning for it makes her financial planning resilient and adaptive, letting her navigate through life changes without jeopardizing her financial stability.
Q: What are sunk costs, and how should we approach them in decision-making?
A: Sunk costs are past costs that have already been incurred and cannot be recovered. In decision-making, we should avoid using sunk costs as a basis for future decisions. Instead, we should focus on potential future outcomes and the benefits and drawbacks of our options moving forward.
For instance, imagine you’ve purchased a non-refundable ticket to a concert for $100. On the day of the event, you fall ill and feel too unwell to attend. Despite this, you might feel compelled to go, not wanting to “waste” the $100 you spent on the ticket. This is the sunk cost fallacy - the $100 is already spent, whether you attend the concert or not.
The rational decision would be to stay home and rest, as the money is a sunk cost and shouldn’t factor into the decision-making process. Instead, the decision should be based on what provides the best value moving forward. Here, the best value is recovering from the illness rather than worsening your condition by attending a concert when sick.
