Ever look back at financial decisions and ask: Why did I do that? Turns out, science can probably answer the question with behavioral economics
Ever look back at financial decisions and ask: Why did I do that?
Turns out, science can probably answer the question. Welcome to the Nobel Prize-winning field of “behavioral economics.”
Its mission: to look at how we humans are hardwired to perceive things such as value, abundance, scarcity and the future — then analyze at how that relates to our financial decisions.
So not only can you learn from your mistakes, you can also learn a lot about what was going on in your head when you made them. Here are six money mistakes we commonly make — and their behavioral underpinnings.
1. Buy now, pay later
Do you tend to spend more when you pull out the plastic than when you count out the cash?
Study after study finds that it’s true for most of us.
Part of the reason: With cash, your brain registers that the money is really spent, says Douglas E. Hough, associate scientist with the Johns Hopkins Bloomberg School of Public Health. You pull it out of your wallet, count it out and hand it to the cashier. That money is literally gone.
With a credit card, you hand it over, but the clerk gives it right back. “You don’t see the result of the transaction until a month later,” he says.
Hough points to economist Amy Finkelstein’s work as a good example of how we let ourselves be taken by out-of-sight payments. Finkelstein, an MIT economics professor, found that states that had electronic toll collection systems would raise toll rates more than states that didn’t, Hough says.
Consumers don’t notice those changes in the same way when they aren’t handing money to a toll taker or throwing it into a bucket, says Hough. Instead of counting and doling out quarters, “it just shows up in a bill” once a month, he says.
And, when you don’t pay cash at that moment in time, “The mind is almost saying ‘I’m getting it for free,'” Hough says.
2. ‘Bill creep’
Automated bill pay, a favorite of retailers, service providers and financial institutions, makes use of a similar lack of tactile payment, says Hough.
“The argument, from the standpoint of a retailer, is that this makes it much more convenient for you, it’s automatically done for you,” and it’s always paid on time, he says. Some will even give a discount if you set up automatic bill payments.
“What happens is that it takes the consumer out of the stream of purchase,” Hough says. “The salience is reduced. You don’t realize how much you spent.” And, if charges increase incrementally or previously free services start carrying a fee, you’re less likely to notice or do something about it, he says.
Once you put a bill on automatic, “You don’t even think about it,” Hough says. “So you aren’t shopping around or cutting services. That takes work.”
3. The value of now vs. later
Many financial decisions, from retirement planning to those supposedly interest-free credit deals, involve weighing the value of money now versus its more hazy future value.
The problem? For human beings, ciphering the true value of resources at a future date doesn’t come naturally, says James E. Burroughs, a University of Virginia commerce professor who specializes in consumer behavior. “Human beings are very short-term oriented,” he says. Possibly, because “most of humanity’s existence is getting through the here and now,” he adds. “So that’s how we think.”
Given a choice between a small, immediate reward now or a very large reward deferred into the future, “human beings will typically take the immediate reward,” Burroughs says. “That’s why we don’t do well with financial decisions,” he says. “It’s why we have credit card balances. It’s why we don’t save for retirement.”
We’re wired to deal with the here and now. We’re not good at considering long time spans.
|— James E. Burroughs|
University of Virginia
4. ‘Hot states’ and big debts
Ever take out a payday or title loan, carry a balance on a high-interest credit card or get a cash advance on your plastic? If so, you were likely consumed with the idea that whatever you were buying (whether it was a visit to a Vegas casino or the local emergency room), you had to have it now.
In those situations, called “hot states,” consumers “are driven by emotion, not thought,” says David Just, a professor of behavioral economics at Cornell University. They’re convinced that having the money immediately is more important than what they eventually have to pay for it, he says.
Consumers coo to themselves, “I’ll do better tomorrow,” and “Everything will take care of itself.” Not thinking about outcomes, they’re “just convincing themselves to do something wrong,” he says. “And it can be devastating.”
5. Fun vs. savings
That same type of thinking makes it difficult to picture future money problems, Burroughs says. While financial planners are advising us to tuck away three to six months’ worth of expenses as an emergency fund, “that requires us to comprehend a future that we’re not very good at comprehending,” he says.
So your mind might hit a roadblock when you compare postponing buying that gaming system that you know you want, in order to save money for a job loss, roof leak or washing machine breakdown that hasn’t happened and may never occur.
“We deal in this world that requires intertemporal trade-offs,” says Burroughs. “And we’re not good at understanding them.” Skipping a workout, eating a plate of chocolate chip cookies, or forgoing that savings contribution one time isn’t that big a deal. But we have trouble calculating the cumulative effects of those same actions repeated over months or years, he says. “We’re wired to deal with the here and now,” Burroughs says. “We’re not good at considering long time spans.”
This is one area where putting your finances on autopilot may actually help you, he says. Have money for your savings (or retirement or college) automatically deposited into an account, Burroughs says. “You never lost it, because you never had that money in your life to begin with.”
6. Too many fees
Sometimes those small, repeated mistakes aren’t something we actively do, but something we simply don’t change. Those passive decisions can be even more costly, says Just.
Some examples: Putting up with a credit card rate hike, using a financial institution that constantly levies fees or ignoring small, unwanted charges on a bill month after month.
“If you’re looking at this as a single instance, then you tend not to care,” says Just. The problem: “It is a single instance, but it will be followed up by a thousand more. This is what allows companies to change convenience fees. And creates prices that are really above-market.”
The lesson from behavioral economics?
“I think the real key is nobody’s perfect,” says Burroughs. “Nobody can avoid making all of these mistakes completely.”
But when you learn how and why you’re vulnerable, you can set up routines that help you compensate, he says. “To the extent that you make yourself a creature of habit — financial habit — the better off you’ll be, and the less stressful your life will be.”
“Pay attention to the little things,” Just advises. “Don’t just re-evaluate your retirement. Re-evaluate the decisions you’re making day to day with your money.”
See related: Summer vacation mistakes that can cost you, Q&A: ‘Dating Our Money’ author Leslie Greenman links love, money, Q&A with Liz Weston, author of ‘No Dumb Questions About Money’