Money is more about mind than it is about math. Our financial decisions are often based on psychology and emotion rather than on pure numbers. Nearly everyone understands intellectually that credit card debt is bad, for example, but for millions of people, this understanding isn’t enough.
A newish group of researchers dubbed behavioral economists have been exploring the gulf between financially optimal behavior and the things people actually do. One reason, said economist Dan Ariely in yesterday’s London Guardian, is sheer habit:
Orthodox economists don’t recognize habits. “They assume ordinary people do a constant cost-benefit analysis on everything they do. But actually, after you reach a decision, you say, ‘That’s the end of it!’— and just continue.” Which is one reason why more competitors entering an industry does not immediately prompt customers to [switch brands].
The article describes other ways in which psychology plays a role in our financial decisions:
- Increased choice makes us less able to choose. This is true in the cereal aisle, but it’s also true when shopping for cars, or for a mortgage. It’s easier to evaluate three products than it is to evaluate thirty. Sometimes choice isn’t a good thing.
- Our habits affect our habits. We are creatures of inertia. If we’re accustomed to buying a certain type or brand of product, we’ll continue to buy it even if there might be a better choice. The “known” is familiar and comfortable.
- We don’t actually know the value of the things we buy. Rather than evaluate how much a new television is worth to us, for example, we allow ourselves to be guided by manufacturer’s pricing and sale information. If we buy a new TV for $1,000 — marked down from $1,300! — we tell ourselves we scored a deal, even if that television may not give us $1,000 in value. (This is why Your Money or Your Life‘s concept of trading life energy for Stuff is so eye-opening to many people.)
- People cannot always figure out what is in their best interest. “Money and risk are abstract, complex things,” Ariely says. Because it’s difficult to know which option is best, retailers can nudge people into purchases. (And perhaps the reverse is possible — maybe people can also be nudged into making smart financial decisions, like opening retirement accounts or paying off debt.)
- We’re swayed by things that do not matter. The article describes how Ariely — a trained economist — spent more on a car just because it came with free oil changes, a decision he regrets. Recently at All Financial Matters, JLP told the story of a woman who traded in her gas-guzzler for that gets better mileage. JLP ran the numbers, though, and concluded that this was a decision that only made sense on an emotional level.
- We tend to throw good money after bad. Though it’s not mentioned in this article, the sunk-cost fallacy is another common mental mistake. Just because you’ve spent money on something doesn’t mean you should continue to spend money on it. It doesn’t even mean you should keep the item. What matters is the item’s future value to you, not how much you’ve spent on it.
If you’re in debt or have spending problems, take time to examine your habits. Do you let emotion affect your financial decisions? Do you buy things you soon regret? Do you tend to make risky investments? If so, consider researching behavioral economics. Understanding why you think the way you do is an important step to changing your habits.
I used to succumb to many of these mindsets, too; I’m sure that I often still do. Lately however, I’ve found myself with a different sort of problem: It’s almost as if I’m scared to spend money. I’ve finally reached a point in my life where I could afford to allow myself small indulgences, but I’m afraid to do so. Am I becoming a miser? I wonder what the behavioral economists would say.
Here are some related stories from the archives:
- Why We Buy: The science of shopping (see also How to spend less: Lessons from Why We Buy)
- Common money mistakes and how to correct them
- How shopping momentum leads to more shopping
If you’d like to learn more about behavioral economics, I highly recommend Why Smart People Make Big Money Mistakes (and How to Correct Them) by Gary Belsky and Thomas Gilovich [my review]. It’s an excellent book, and very readable. Borrow it from your public library.