Reducing Spending: Helpful bits of Psychology to Know

1. We are poor at “affective forecasting,” or predicting how we’ll feel—in large part because we tend to project our present emotions into the future. As a corrective, hink not just about how you will feel about getting the item, but think about how you’ll feel after you’ve had it for a while.

Remember those items of clothing in your closet that still have the tags on them, or the books or DVDs you’ve bought but never managed to read or watch.
Also think about the downsides of the purchase—the excessive packaging waste if you’re an environmentalist, the need for storage, the decrease in your checking account.

2. It is helpful to know something about brain organization—not to be a brain scientist but to know that we have a “triune” brain—a “reptilian brain” that helps us with basic biological, sensation & perception and movement, a “mammalian brain’ that is focused on emotions and memories, and a “hominid brain” in the prefrontal cortex that is focused on our higher-order reasoning powers. Desire is rooted in the dopamine systems of the mammalian brain, and our hominid brain, with maturity and practice, usually has the ability to control our desires. It is also useful to know that “wanting and liking” are separate from each other, according to Kent Berridge’s work, and this means that it is possible to want what we ultimately do not like, which becomes the case in many addictions.

3. A key idea from psychology is "automaticity"—we only use the higher order powers when we really need to and much of the time we operate on automatic pilot. So you want to make the desirable behaviors like saving automatic and the less desirable behaviors like overspending more conscious or mindful.

Hints:

• Put your saving and investing on automatic pilot.
  Help yourself become more mindful of your spending by
  Making a list and sticking to it when shopping
  Tracking your spending. If you sign up for an online “data aggregator” account on Mint.com, wesabe.com, yodlee.com, or mvelopes.com and input your bank account information, which is secure, your spending will be automatically tracked, and then you can make an appointment with yourself each week to check that you are on track. Or if you’re a paper and pencil type, use envelopes, or if you just don’t want your data on the web, get a program to put on your PC—I like You Need a Budget.

4. Making a precommitment and keeping track of how long you’ve been on track can be useful because it’s easier to make a commitment in advance of being in the actual situation, and also because we hate to break streaks (Rachlin’s work).

5. Fight automaticity by building in a delay—I use my amazon.com shopping cart and wish list to keep track of things I want to buy, but never allow myself to buy them immediately. I’d say that I ultimately buy 10-20% of the things that I put on the list and felt that I “needed.”
In the interim, I look for alternate ways to get hold of them—for example, from the library.


6. Pay attention to WHY you’re buying—are you buying a symbol of what you want—will buying the 20th cookbook actually make you the cook you desire, or is this a purchase an image of a “desired” possible self.


7. Channel factors—we are very influenced by how easy or hard it is to do things (eg Leventhal tetanus vaccination study), so make it hard for yourself to spend by
don’t go shopping for recreation—find substitutes
Don’t bring your credit card—limit yourself to cash on hand, which you have precommitted yourself to.

8. For women, especially, social support is key. Women often make shopping recreational, so its important to make “not shopping” a fun part of your social life too. Develop a support group around simple living, or around an alternate activity like cooking, watching videos at home, or hiking.

9. When you do spend, remember that what people often end up valuing most in retrospect is experiences rather than material things, so try to make room in the budget for a day at the shore or some other fun experience, and choose that rather than the new handbag, because ultimately you will treasure the memory and the handbag will end up donated to goodwill when it goes out of style.

My Rules for Creating a Solid Financial Future

Yesterday's (5/17/08) New York Times featured an article by Ron Lieber titiled, "Five Basics for Building a Solid Financial Future.") This reminded me of other "summary rules" posts I've seen, most notably the two below:

http://www.thesimpledollar.com/2007/11/29/everything-you-ever-really-needed-to-know-about-personal-finance-on-the-back-of-five-business-cards

http://blog.mint.com/blog/finance-core/three-principles-of-personal-finance-all-you-need-to-know-for-financial-success .


After thinking long and hard (and based on these and other readings!), I have compiled my own list of rules.

1. Spend less than you earn. (You can do this by either or both spending less and by earning more.)
2. Be prepared for the unexpected.
3. Know your goals, and allocate risk accordingly.
4. Invest primarily using index funds.
5. Only get into debt when it is leverage on an investment.
6. Automate billpaying and investing as much as possible
7. Adjust the price of items to reflect their cost to you in time spent working before you decide whether to pay it (adjust upwards to reflect both income taxes and the additional costs you incur by working; a good approximation for many working middle class people will be a 50% increase).
8. Know what you are buying, which is not necessarily what they are selling (ATT is selling "relationships" with "Reach out and touch someone," but you are only buying a phone service; cosmetics are selling the vision of yourself as sexy and desirably but you are only buying a lipstick), and get what you pay for (be a good consumer advocate for yourself; ask for service, make returns if the product is unsatisfactory).
9. Use the power of time to make your money go further (take advantage of compound interest on investments; give yourself a day's delay to limit impulse spending).
10. The ultimate financial goal is financial independence.
11. Invest not only financially, but in relationships, self-development, and in your health.
12. In deciding what to spend or invest your money in, remember that making a decision that is "good enough" rather than "the best possible decision" maximizes satisfaction (Schwartz) and that, in the end, people value experiences more than material goods (Van Boven), regret things not done more than the things that they have done (Gilovich), and will often end up happier than they expected with difficult decisions due to the operation of the psychological immune system (Gilbert) (the names cited are the psychologists who have done relevant research).


*To earn $30 to spend, you need to earn more than $30 because of taxes--federal, state, and local income taxes, Social Security and Medicare, state unemployment insurance--totalling these together, using the average rather than the marginal federal tax rate will approximate 25% of income for most people, so you need to earn 1.25 * $30 = $37.50 to have $30 to spend, just by adjusting for taxes.
But one also must consider that one spends a lot of money to earn money (as is elaborated in Joe Dominguez's and Vicky Robbin's Your Money or Your Life, from whom this next idea is taken)...one spends on increased transportation costs (gas, parking, increase depreciation and repair), increased food costs (more meals out and prepared food bought at the grocery store because you don't have time to cook), increased costs for clothing (professional clothing, dry cleaning, professional haircuts, cosmetics), and increased "stress reduction costs" (massages, vacations that you need because you're stressed from working), and increased technology/communication costs from trying to keep up with the pace of business life, not to mention child care costs for those who have children (or even in some cases, "fur kids"). Say that those expenses total 20% of your total spending.
Dividing 37.50/26 yields 1.5, or a 50% premium on the stated price--what you really need to earn in order to pay it.

You always want to try to get the best deal, right? NOT!

On the face of it, it sounds like trying to get the best deal is a good thing. Who wouldn't want to get the best possible product for the least possible price? But economic theory and psychology research show that this isn't what you always want to do.

From economics, one relevant concept is opportunity cost. The cost of a decision includes not only its price, but also the cost of the time and effort spent deciding. If it takes you thirty minutes to decide what you're having for lunch, then that's thirty minutes that you're not able to spend taking a walk, doing errands, or earning more money. So while it's probably worth it to spend 30 minutes looking up reviews on that hundred-dollar toaster oven you're thinking about buying, it's probably not worth it in terms of the time and effort sacrificed to spend the same 30 minutes agonzing over a $6.95 lunch entree.

Another relevant concept from economics is the principle of diminishing returns. Let's go back to the toaster oven purchase example (I bought one of these just last week). With the advent of the internet, doing a bit of basic research is very easy--amazon.com and other online retailers usually offer consumer reviews, and there are independent review sites such as epinions as well. Twenty or thirty minutes spent browsing one of these sites can tell you which products the majority of (commenting) buyers are happy with, give you an idea of the price you can expect to pay, and the relevant features to look for in making your decision. What you learn in the first half hour of research should make your decision a significantly better one. (To quantify it, we'll say that your deicision is now twice as good, or 100% better). But some people continue their research well beyond this time frame. Spending 4 hours, for example, on online research for a hundred dollar product is not worth it. Yes, you may end up with a better product, but the improvement in quality in what you find in your second, third, and fourth hours of research over what you already learned from your first hour of research is not that much better. Whereas your first 30 minutes of research yields you an outcome that is 100% better, the second half hour may add only a 50% improvement beyond that. Using the idea of "halving" your improvement, by the end of your third hour of research, you still may be finding a better product that you found after 2.5 hours of research, but now it's only 3% better--not enough better to justify the additional time and effort.

According to research in psychology, however, not everyone recognizes this. Professor Barry Schwartz of Swarthmore College, in his book The Paradox of Choice, proposes that people can be divided into two types, Maximizers and Satisficers. Maximizers are motivated to get the best possible outcome, while Satisficers are happy with an outcome that's "good enough." Maximizers are particularly likely not to recognize the diminished returns from extra time and effort spent shopping. So they spend more time, may actually end up with a marginally better product, but end up much less satisfied with their purchases than Satisficers do.

The conflict between psychology and economics

One of the underlying assumptions of economics is the idea of human rationality--that people will attempt to maximize their own well-being, or "utility." In contrast, some perspectives in psychology--most notably the psychoanalytic--have presumed the fundamental irrationality--the "psycho-logic" (as opposed to logic) of human beings.

The conflict between perspectives has eroded over the last 20 years as the new integrative field of behavioral economics (also known as behavioral finance) has developed. My goal in this blog will be to explore some of the ideas and concepts from both psychology and behavioral finance and to consider how understanding these can help people develop a higher level of financial well-being, or fiscal fitness.