Smart remedies for foolish spenders

Making bad money decisions is a hallmark of humanity, but lessons from behavioural economics can help improve our personal finances

The guest authors are Dan Ariely and Jeff Kreisler.

Most of us think about money a lot: how much we have, how much we need, how to get more, how to keep what we have and how much our neighbours, friends and colleagues make, spend and save. Luxuries, bills, opportunities, freedom, stress—money touches every part of modern life, from family budgets to national politics, from shopping lists to savings accounts.

Thinking a lot about money would be fine if, by thinking more about it, we were able to make better decisions. But that’s not the case. As innumerable studies in behavioural economics have demonstrated across a range of situations, making bad money decisions is a hallmark of humanity. We’re fantastic at messing up our financial lives.

But don’t despair. If we put our minds to it—and apply some lessons from behavioural economics—we can individually and collectively improve our financial decision-making. The first step is being aware. The next step is turning that awareness into an effective plan.

Here are some of the most common valuation mistakes that we make—and suggestions for how we can avoid, correct or mitigate them.

We ignore opportunity costs. Think about transactions in terms of opportunity costs by considering more explicitly what we’re sacrificing for what we’re getting. For instance, we can translate dollars into time—how many hours of wages, or months of salary, we must work to pay for something.

We get misled by relative prices. When we see a sale, we shouldn’t consider what the price used to be or how much we’re saving. Rather, we should consider what we’re actually going to spend. Buying a USD 60 shirt marked down from USD 100 isn’t “saving USD 40.” It is spending USD 60.

We should try not to think in percentages. When data is presented to us in percentages (for example, a financial adviser’s fee of 1% of assets under management), we should do the extra work and figure out how much money is really on the line. The money in our pocket is tangible; it exists in absolutes. USD 100 is USD 100. Whether it’s 10 % of a USD 1000 purchase or 1 % of a USD 100,000 purchase, it still buys the same 100 packs of Tic Tacs.

We compartmentalize. Money is fungible. Every dollar is the same. It doesn’t matter where money comes from—our job, an inheritance, a lottery ticket, a bank robbery. The money is all ours and it belongs, in fact, to the general “our money” account. If we find ourselves splurging with certain “kinds” of money—just because in our mind the money belongs to the “bonus” or “winnings” account—we need to pause, think and remind ourselves that it’s just money. Our money.

We avoid the pain of paying. Feeling the pinch of paying helps us at least consider the value of our options and the opportunity costs. The pain helps us pause before purchasing and consider whether or not we really should spend our money then and there.

The problem, of course, is that the people who make payment systems don’t share our desire to slow down and consider alternatives. That is why the best solution for preserving the pain of paying may be as simple as: “Use cash, not credit cards.” Or maybe it’s even simpler: “Punch yourself every time you spend money so you really feel it.”

We trust ourselves. When it comes to spending, trusting our past decisions can create big problems. We should avoid doing something all the time, like getting a USD 4 latte, just because we’ve always done it before. From time to time, we should stop to question our long-term habits. Those of us who don’t learn from our own spending histories are doomed to repeat them. We should ask if a latte is really worth USD 4 to us, or if a cable bundle is worth USD 140 a month, or if a gym membership is worth fighting for parking just to look at our phone while trudging on a treadmill for an hour.

We overvalue what we own and what we might lose. We love to have stuff, and once we acquire it, we naturally think our own stuff is the best in some objective sense. But it’s not.

We shouldn’t trust that the home renovations we are going to make will increase the resale value of our home. We should recognize that our taste is unique, and that other people might see things differently. Renovating is fine, as long as we head down that path recognizing that it might only increase the value of the home to us.

Sunk costs cannot be recovered. If an amount is spent, it’s spent. The past is past. When making decisions, consider only where we are now and where we will be in the future.

We believe in the magic of language and process. The great 20th-century philosophers Public Enemy put it best: “Don’t believe the hype.” If the description of something, or the process of consuming something, is long-winded and overblown, we’re probably paying for that description and process, even if it doesn’t add any real value. Watch out for irrelevant claims about the effort that went into producing something: There is rarely a good reason to pay $300 for an artisanal hammer.

We make expectations a reality. Expectations give us reason to believe that something will be good—or bad, or delicious or gross. They change our perception and experience without altering the true underlying nature of the thing itself.

Expectations can alter our experiences for the better, of course. Once we buy a bottle of wine, we may want to manipulate ourselves into believing it’s worth USD 20 more than we paid. We can let it breathe and swirl it and smell it and put it in a fancy glass knowing that with all of these tricks, it’s going to be a better experience.

What we don’t want is to buy a bottle of wine because someone has tricked us into spending USD 20 more than we should. We hear the sommelier describe the vintage and tannins and awards and reviews and hints of elderberry and believe it must be worth a lot. That’s being used by expectations.

We overemphasize money. Prices are just one of the many attributes that signal the value of things. They may be the only attribute that we can easily understand, but they’re not the only attribute that matters. When we move from comparing money to things to comparing things to things directly, it puts our choices into new perspective. For example, when looking at a vacation, consider the amount the vacation would cost in terms of movies you could attend or wine you could drink.

We’re all floating on that rough sea of uncertainty; don’t let someone else’s idea of value—that is, the price—be what you grab on to for salvation. A price is just a number, and while it can be a powerful part of a decision, it doesn’t, and shouldn’t, mean everything.

Adapted from the new book by Mr. Ariely and Mr. Kreisler, “Dollars and Sense: How We Misthink Money and How to Spend Smarter,” published by Harper (an imprint of HarperCollins, which, like The Wall Street Journal, is owned by News Corp).

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