Ever wonder why you spend money on a pair of pants that don't even fit you? Or buy a handful of lottery tickets when you know your chances of winning the jackpot are next to nil? You're not alone. The Nobel Prize-winning science of behavioral finance has tackled these questions for several decades and helps explain why people relate to money as they do. In a perfect world we'd all resist the urge to splurge, and instead save the right amount for a cozy retirement. But money habits are not rational, as many economists, psychologists and neuroscientists point out. "Economists used to regard people as always making rational financial decisions," says John Smith, associate professor of economics at Rutgers University-Camden. "However, in the past 30 years, a huge amount of evidence has accumulated showing that most people suffer from all sorts of costly, systematic biases."
Call it gut instinct or rules of thumb: Most people rely on emotional shortcuts to make their financial decisions. Those rules, psychologists say, evolved as cognitive shortcuts in the human brain — if you think through every move you make, it takes a long time. But in the financial realm, shortcuts can make you see patterns that don't exist and point you toward irrelevant information.
By understanding how many of your financial decisions are subconscious, you can become more aware of ways to change your usual way of doing things — which can lead to better financial habits.
Common Problems and Simple Fixes
Problem 1: The Future is distant.
Humans have a hard time conceptualizing the future, notes James E. Burroughs, professor of commerce at the University of Virginia. For early humans the most vexing threats were the most immediate — securing food and keeping marauding beasts away — not some potential threat many years later. Sensational news headlines notwithstanding, the present is fairly safe, thanks to modernity, a plentiful food supply and beasts that stay away from human population centers. But when it comes to money, we still have trouble making careful judgments about the future.
"Money in the distant future is given less weight than money sooner," Smith says. "This is called the present bias." For example, a vacation next year is much more concrete than buying a home five years from now, or retiring in 30. "The more stretched out the consequence," Burroughs says, "the harder time we have making a proper evaluation of the consequences." Economist Keith Chen of UCLA believes the language you speak also affects your savings behavior. Countries with languages that distinguish little between present and future tense have greater savings rates, he noted. People in those countries don't view the future as far off as English speakers do.
Problem 2: Credit isn't "real."
People spend more with a credit card than when they pay using cash. Why? With plastic you only feel the pain of spending later, when the bill arrives. "Cash makes the pain of paying more transparent," Burroughs says. Unsurprisingly, highway toll revenues rose drastically shortly after electronic-pay toll booths replaced cash lanes. Drivers simply didn't notice what they paid if they used a transponder. Similarly people tend to overspend when visiting another country. "Foreign currency tends to look like Monopoly money," Burroughs says, "so people don't think it's real." However, the longer you spend that currency, the more "real" it becomes, and the effect starts to decline.
Problem 3: Money doesn't translate into time.
Most people know how much money they make each year. But how many could say how much they earn per day? "That's an important way of looking at money, and it can help frame spending decisions in a different way," says John Buerger, a financial planner in San Luis Obispo, California. "We want to think of ourselves in as grand a context as possible," Buerger says. A salary of $65,000 a year certainly sounds better than $178 a day. Yet when faced with day-to-day spending decisions, $1.50 for a cup of coffee or $40 for a trendy top are trivial amounts against $65,000 a year. Even so, they add up.
Problem 4: Tracking is difficult.
Many people are unaware how much money they spend each day, and the money quietly seeps out. "Often, money is going out the door to pay for stuff that isn't important to people," Buerger says. Buerger asks his clients to keep a journal of their spending for 30 days, taking down each transaction 24 to 36 hours after it's made. That's recent enough, but not in the moment, so people can look at those purchases more objectively. He then asks clients to rate each purchase 1 to 5 based on the value they receive. "For some people, coffee has tremendous value," he says. Buerger reports that by tracking their spending, people become more aware and automatically reduce their spending 3 to 5 percent.
That's when he tries to reposition behaviors often seen as painful into pleasure. Take savings: It's often seen as a sacrifice. To change behavior, saving should be pleasurable. And that's why Buerger asks his clients to focus on spending that brings them joy.
It's hard to overemphasize how powerful it is to start saving at an early age. A person who saves from age 25 to 35 and then stops ends up with more money at age 65 than someone who saves the same amount from age 35 to 65.'For someone who is making $50,000 to $60,000 a year, they are going to find that $150 to $200 a month can be repositioned for saving,' he says. Do that for 30 to 40 years, and the sum you end up with is "massive," Buerger says.
Decisions Made with Emotion
Avoiding financial temptation makes good sense — but, avoiding financial plans for the future does not. Here are some questions to help you determine if you're making an emotional financial decision.
- Does it bring me joy?
To some people, purchases, such as shoes, are pure joy. For others it might be a watch, a necktie or a decadent meal at the hottest restaurant in town. Rank your purchases on a scale of 1 to 5, with 5 being the most enjoyable. If you find most of your purchases rank low, they don't bring you much fulfillment, and it's time to think of better ways to spend your money. Not only does this make your spending more meaningful, but you also might end up saving money.
- What's my return for the purchase?
There's nothing wrong with buying a lottery ticket here or there, but understand your chances of winning a jackpot are frightfully low (1 in 175 million). Yet people still believe they could be one of the lucky few because they see real-life examples of people who have won. They pay too much attention to low-probability events such as winning the lottery.
- What impact will waiting have?
Even if you don't earn much, there's no substitute for time, which you have in abundance when you're young. As you get older, life becomes more financially complicated and more expensive, and there's no way to know how much money you can dedicate to savings. Small amounts saved and invested today pay big dividends in the future.