Rethinking Money for the New Year
By Dan Ariely
January 2, 2010
In today’s economy, consumers and financial institutions alike are constantly on the lookout for new ways to reduce spending. As you read this article, consider these questions: What cost-cutting habits has your organization developed, and are they rational? Do you recognize irrational or habitual spending tendencies in your own customers and members? If so, how can you help them make better decisions that lead to improved savings?
Money is an integral part of modern life. We constantly make decisions about whether we’re willing to pay for different products and, if so, how much we are willing to pay. In fact, we make decisions about money so often that we consider money to be a natural part of our environment.
However, money is a relatively recent invention, and despite its incredible economic usefulness it does come with its own set of problems. In particular, it turns out that decisions about money are often non-intuitive and, in fact, quite difficult. Consider the following situation as an example: You are thirsty, tired, and annoyed and just want a cup of coffee. You see two coffee shops across the street from each other. One is a specialty coffee shop that sells handcrafted, designer coffee and the other is Dunkin’ Donuts, which sells standard, decent coffee. The price difference between the two options is $1.75 for your cup-a-joe. Now, how do you decide if the benefit of the handcrafted coffee drink is worth the additional $1.75?
What you should do (if you wanted to be rational about it) is consider all of the things that you could buy with that $1.75, now as well as in the future, and decide to buy the expensive coffee only if the difference between the two coffees is more valuable than all of those other possibilities.
But of course this computation would take hours, it is incredibly complex, and who even knows all the possible options to consider?
So what do we do when we need to make decisions but making them “correctly” is too time-consuming and difficult? We adopt simplifying rules, which academics call heuristics, and these heuristics provide us with actionable outcomes that might not be ideal, but that help us to reach a decision. One of the heuristics we often use is to look at our own past behaviors, and if we find evidence of relevant past decisions, we simply repeat those.
In the case of coffee, for example, you might search your memory for other instances in which you visited regular or fancy coffee shops. Then you might assess which behavior is more frequent, and tell yourself, “If I’ve done Action X more than Action Y in the past, this must mean that I prefer Action X to action Y” — and as a consequence, you make your decision.
The strategy of looking at our past behaviors and repeating them might seem at first glance to be very reasonable. However, it suffers from at least two potential problems. First, it can make a few mediocre decisions into a long-term habit. For example, after we have gone to a fancy coffee shop three times in a row, we might reason that this is a great decision for us and continue with the same strategy for a long time.
The second downfall is that when market conditions change, we are unlikely to revise our strategy. For example, if the price difference between the regular and fancy coffee used to be $0.25 and over the years has increased to $1.75, we might stay with our original decision even though the conditions that supported it are no longer applicable.
Examine old habits
In light of our current financial situation, many people these days are looking for places to cut financial spending. Once we understand how we use habits as a way to simplify our financial decision- making, we can also look more effectively into ways to save money.
If we assume that our past decisions have always been sensible and reasonable then we should not scrutinize our long-term habits. After all, if we’ve done something for five years, it must be a great decision. But if we understand that long-term, repeated behaviors might reflect our habitual decision- making in the face of complex financial decisions more than they reflect what is truly best for us, we might first examine our old habits and carefully consider whether they indeed make sense or not. We can examine our subscription to the ESPN Sports Package, our annual subscription to the opera, our yearly Disneyland vacation, or our monthly visit to the hairstylist.
By examining these habits — and quitting them when it makes sense to do so — we might actually discover ways in which we could reduce our spending on a long-term basis.
Yes, money is complex, and it is incredibly difficult for us to carefully examine every purchasing decision we make. But the advantage of examining our habits is that it might lead us to create good ones that will benefit us for a long time.
May you have a happy and exciting new year
This column first appeared at http://www.deluxeknowledgeexchange.com
(c) Predictably Irrational