Understand the Psychology of Spending
Sadly, our brains aren’t wired to make us rich. Thanks to evolutionary quirks in how we view the world and make decisions, behavioral economists tell us we often do exactly the wrong thing when it comes to money and accruing long-term wealth (such as with our savings accounts, our retirement accounts and sticking with budgets).
Don’t despair, though. There are plenty of ways to either short-circuit our mental foibles or even use them to our advantage so we can still come out rich. Here are five mental patterns that make us poorer — and how to overcome them.
Mental Pattern: Hyperbolic Discounting
Simply put, we prefer short-term satisfaction over long-term gain. The farther out the future benefit, the more we discount its value. Is it any wonder so many of us have trouble saving for retirement (or anything else)?
- Make savings automatic so you don’t have to constantly choose saving over spending. You make the decision once and it’s done.
- Visualize your goals. Put a picture on the fridge of the vacation home you want to buy or the activities you want to pursue in retirement to make your goal more real and thus harder to discount.
Mental Pattern: Mental Accounting
We tend to value, and treat, sums of money differently depending on where the money comes from and where it’s kept. This is why, for example, many people spend more when they use credit cards than when they use cash. Because of mental accounting, money spent on cards doesn’t seem as “real” as cash they hold in their hand. The obvious solution? Use cash!
- Use savings sub-accounts to save for specific goals. Most online banks allow you to set up multiple savings accounts, each labeled for a different purpose, for free. You’ll probably think harder about dipping into a savings account labeled “Hawaii vacation” than you might if it were just labeled “savings.”
- Save every $5 or $10 bill you get. This tip drives rationalists nuts, since it’s such a random way to save. But that’s why it works. It takes advantage of mental accounting, plus there’s an element of gambling that makes it fun, since you typically don’t know when your targeted bill will show up in your wallet.
- Use non-retirement savings to pay off credit card debt. Bite the bullet since it’s irrational to keep savings earning less than 1 percent while your credit card debt is costing you 15 percent or more.
Mental Pattern: Status Quo Bias
Two British researchers described this quirk as “an exaggerated preference for the status quo,” because it requires “less mental effort than considering a proactive course of action.” In other words, we’re lazy. We’ll stick with what we have rather than bestir ourselves to consider the alternatives.
- Sign up for automatic increases. Many employers now boost workers’ 401(k) contributions 1 percent or so each year. Sometimes it’s the default option, while other times you have to sign up. If your employer won’t do it automatically, steel yourself to visit Human Resources once a year to boost it yourself. (Mark it on your calendar to increase the odds you’ll actually do it.)
- Use target date retirement funds. These funds choose your asset allocation and regularly rebalance your investments — important tasks you should be doing but likely aren’t, because of your lazy brain.
- Beware free trials. Marketers know that if you’re offered a trial subscription, you’re unlikely to cancel before the true cost kicks in. Don’t tell yourself you’ll remember to take action, because your status-quo-loving mind will make you forget.
Mental Pattern: Loss Aversion
We hate losing roughly twice as much as we love gaining. People who don’t understand this peculiarity often don’t invest enough in stocks because they’re far more worried about potential losses than they are the larger potential gains. What to do?
- Limit your exposure to stock market noise. Don’t obsessively check your portfolio; once a quarter, or even once a year, is enough. What matters is not what’s happening now, but what will happen over your decades-long investment horizon (which is a big gain over time).
- Dump your losers. People often resist selling a stock at a loss, or getting rid of their clutter in a garage sale, because such actions make real the fact that the money they spent is gone. Well, it’s gone regardless, and getting rid of your losers may free up money for more productive purposes.
Liz Weston is an award-winning journalist and author of several money books, including the best-selling “Your Credit Score.” She writes about personal finance at her site AskLizWeston. You can like her on Facebook and follow her on Twitter.