Throwing down cash on an expensive purchase when we should be using it to pay down debt. Caving in to a splurge we know we can’t afford, or spending money we don’t yet have. So why is it that while we know what we should be doing with our money – spend less, earn more and invest the difference – we oftentimes make irrational financial decisions?
Behavioral finance can help us get to the bottom of why we might make these harmful choices. A field of study that combines psychology and economics, behavioral finance explains why we might make less-than-wise decisions with our money.
We talked to Emily Guy Birken, a personal finance writer and author of “End Financial Stress Now,” on how behavioral finance theory can help us better understand our poor money choices, and what we can do to turn them around.
Ever experience lifestyle inflation? It may be in part to something called hedonic adaptation. This is the phenomenon where you get used to what you have, Birken explained. Therefore, you feel the need to upgrade. For instance, while the purchase of a trendy coat is initially thrilling, that excitement fades over time. So, the things we buy today no longer satisfies us later. That’s why lifestyle creep is so easy to fall victim to, Birken said.
How to fight it: Express gratitude on the regular. You can combat hedonic adaptation to an extent by remembering what you’re thankful for. You can also spend discretionary money toward small and regular pleasures, rather than big purchases. This will give you small bursts of satisfaction without busting your budget.
Also, avoid anything that will trigger your jealousy, Birken said. For instance, not watching “The Real Housewives of Beverly Hills” or following the feeds of your favorite Instagram lifestyle influencers are also great ways of nipping hedonic adaptation in the bud.
Anchoring helps you figure out a fair choice for something without having to do extensive research. As Birken explained in her book “End Financial Stress Now,” an anchor is a price point to help you gauge how much something should cost.
So, let’s say you’re at a high-priced store and you’re scouring through the clothing rack. The lowest-priced item is $70. That $70 shirt seems like a steal next to the hundred dollar ones. And since $100 is your anchor, this makes you believe you’re getting a deal for the $70 shirt. When in fact, a $30 shirt is something you’d be just as fine with. Anchoring is used at discount retailers when they include the “compare at” price against what they’re charging you. That’s to have you believe you’re getting a bargain, when in fact it’s a little more than you might pay otherwise.
How to fight it: If you’re shopping in a store, do some research online to check the price on a specific item beforehand. And to limit your spending, carry cash instead. Studies show that carrying larger bills can help you save money. That’s because we view larger bills as having greater value and aren’t as likely to part with them than say, a handful of singles in the same amount.
Humans naturally prefer instant gratification over long-term gains. For instance, if someone offered you a cookie today or a half dozen cookies in a week, chances are that you’ll go for the first choice. That’s why people put off saving for retirement, an emergency fund or other goals where you’ll benefit down the line.
How to fight it: Paying with cash can cause pain or discomfort, Birken said. In turn, credit cards decouple the pain from payment from the act of buying something. So, you feel the pleasure of the spending in the here and now, and suffer the consequences, so to speak, later. This can, in turn, exacerbate hyperbolic discounting. To combat it, use cash or debit card instead.
This is the cognitive bias that makes us believe we will be able to resist temptations in the moment. So, in turn, we overestimate our own impulse control. And because willpower is a resource that we only have so much of, oftentimes we cave in to the lure of temptation. So, while you think you can avoid buying anything during the mega sale at your favorite shoe store, chances are you might cave in.
How to fight it: If you know that you will be facing a temptation, make it impossible for you to succumb to the temptation, Birken recommended. “This is the basis of the old personal finance advice to freeze your credit card in a block of ice,” she said. “It’s impossible to succumb to a momentary temptation to make an unnecessary purchase if your credit card is frozen.”
Sure, freezing your credit card is a drastic measure, but perhaps you can have a trusted friend hold on to your credit cards when you’re out shopping. Or don’t browse online in the first place. (Yes, there is a danger to simply window shopping.)
By understanding how our innate behaviors and reasoning can lead to poor money choices, we can avoid making them in the first place. The more you know, the less cash you will blow.
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