“Illusion is the first of all pleasures.”
Some time in elementary school, you were probably asked the question about which was heavier: a pound of bricks or a pound of feathers. It was the basic test to see if you understood the difference between mass and weight.
There’s an equivalent question for your retirement planning (hey, as a Fort Worth retirement planner, I should ask these questions, right?).
If an annuity yield is 6%, which would you rather have? $500 a month in income or $100,000?
Yet, depending on the magnitude of those numbers, people’s answers change.
To understand why our answers change, we must understand psychophysical interpretations and how our reactions to noises and lights relates to our interpretation of how much money we have.
We’ve looked at psychophysical numbing before in the article “Novocain for Monkey Brain,” where we saw how we view charitable efforts to save one child as more powerful than equivalent efforts to save thousands of children.
Our mental interpretation of the intensity of events is more focused on the rate of change of the event rather than the magnitude.
Let me give you an example.
Imagine you’re lying awake at night trying to count sheep. The bedroom is dark, and you’re on your back, eyes wide open.
Your spouse walks in and, unaware that you’ve already gone to bed, turns on the light.
You cringe and utter a Gollum-like wail: “Ahhhh! The light! It hurts us!”
Fortunately, there’s a dimmer, so she dims the lights some. But, your pupils, still in full on defensive mode, haven’t adjusted yet. You hardly notice that the lights are dimmer. Your reaction is still “LIGHTS ON! PAIN! BLIND!”
When we’re exposed to large changes in an external stimulus (think of when someone’s turned up the radio’s volume knob to its highest setting and you turn on the radio), we notice immediately, but we barely notice subsequent small adjustments (going from 11 to 10 on the volume control…name that movie).
The Volume Knob on Our Perception of Wealth is Broken
There’s a similar effect happening with regards to our perceptions of money and how much is enough.
If I gave you $1, you’d be happy, but the effect on your life would be inconsequential. Same with $10, and probably with $100. Once we get to $1,000, we start talking about real money. Keep adding zeroes. At a million, you’re really happy, and at ten million, you’ve got more money than you could ever spend. But, one hundred million wouldn’t make you much happier than ten million, and at a billion, you’d just be racking up the score with no purpose.
There are a couple of points at which our attitudes about that money change: the point at which we’re talking about “real” money at the lower end – enough to have some sort of impact on you – and the point at which you can’t imagine being any happier for having received more money – the point of diminishing (or diminished) returns on the additional amount.
UCLA’s Shlomo Benartzi, NYU’s Hal Hershfield, and the University of Chicago’s Daniel Goldstein conducted research to determine what our inflection points were when we thought about annuity and pension income versus equivalent lump sum amounts of money.
Because we have trouble converting lump sums into monthly income, we shift our preferences from lump sums to monthly income as the monthly income increases.
In the chart above, people perceived $500 a month as not a lot of money, and perceived the equivalent lump sum – $100,000 in this case – as more valuable. This phenomenon is called the “illusion of wealth,” meaning that we think that we have more wealth than we actually do, since the biggest function of wealth is our ability to convert it into income to pay our day-to-day expenses. However, as the amount of monthly income increased, the perception of a monthly income became more valuable than its equivalent lump sum, even though, from the information given in the scenario that the researchers presented, both amounts were financially equivalent.
Furthermore, as we see in the chart above, we become less and less sensitive to increases in wealth or monthly income over time – just as we don’t notice a slight dimming of a bright light if it was pitch black just a few moments ago. We become psychophysically insensitive to the changes, even if they are meaningful changes.
The problem with the illusion of wealth is that it affects our saving and investing behavior as well. When the people in the aforementioned study were asked about their desire to save and invest, people who thought in terms of a lump sum had less desire to save and invest money, for, after all, $100,000 still sounds like a lot money. When they thought in terms of monthly income, they were more inclined to save more, since they were dealing with smaller numbers.
In both instances, people were less likely to be inclined to spend when they were wealthier than when they had less money, meaning that we’re more likely to take our foot off of the accelerator as we get closer to our retirement target number.