The psychology of money and habits
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 another. 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 they help us to reach a decision. In the case of coffee and other, similar decisions, 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 fancy coffee shops. Assess which one of those two behaviors is more frequent and then you 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 also 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 the conditions in the market change, we are unlikely to revise our strategy. For example, if the price difference between the fancy & standard coffee shop used to be 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.
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 hairdresser. 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.
Quote: “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.”
but we would have to be careful not to fall in the “old habits work fine” that you mention in your post and continuosly apply a updated approach!
Can we really do it all the time without ending up feeling exhausted? … It gets circular…
Love ur posts!
Simone
Thank you very much for your most useful studies on some of the phsycologies behind purchaseing desisions. Also how marketers can tap into this knowledge to help grow there bussinesses.I was put into contact with your site from the league of extrodinary minds. Thank you Rod and Kimberly Warren
I suspect that the less a habit is tied up with one’s personal image of oneself, the easier modify it. It may be more comfortable to explain to friends why you’ve dropped the cable sports package (I’m reading more these days) or why you’re not making the annual trip to Disneyland (the new Small World exhibit traumatized Jimmy) than to explain why you aren’t patronizing Starbuck’s anymore (assuming your friends aren’t wifi-ing at Dunkin Donuts)or in your usual seat at the opera. No doubt, your observation that “the advantage of examining our habits is that it might lead us to create good ones that will benefit us for a long time” is solid advice. But habitual spending decisions are seldom just about the money and I think for most people self-image is downwardly sticky.
great comment Susan! Mick Jagger sings “old habits die hard, harder than November rain”. I totally agree with your suggestion that the more a habit is tied to one’s image of him/herself the harder it is to drop it.. and, especially, it is not all about money in these cases..
Dan, I would like to thank you for your great insite. I don’t have your expertise but I have a comment that I would like to share.
You said “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.”
As beneficiary as that might be to every one, it has just one slight disadvantage. Please allow me to explain. If a person examines one of his (generic for his or her) habits and then he realizes that his habit is not as good as he wants and decides to make a new good habit. For example: he doesn’t eat breakfast and decides to start eating breakfast since it is good for his health. If for whatever reason he was not able to change he will see it that he has failed. Since no one wants to take the risk of being a failure then no one want to examine his habits.
When I got to your chapter on FREE! it reminded me of this story:
http://www.guardian.co.uk/business/2008/nov/08/automotive-industry-business
This may be funny (to some):
http://www.gummy-stuff.org/halloween-stuff.htm
:^)
I was referred here because of my discussion topic on the Quantitative Finance Network group on Linked In.
http://www.linkedin.com/groupAnswers?viewQuestionAndAnswers&discussionID=7657527&gid=77472&commentID=8339564&trk=view_disc
Why do people usually buy eggs that cost the most?
Efficient market theory and classical economics sometimes seems bogus. What’s that got to do with the price of eggs? An awful lot — if people always acted rationally, they would buy eggs that cost the least per ounce, but people hardly ever do that. I know I do so, but I don’t know of anyone else who does.
I came across one of your videos (posted on FB) and watched it. I was quite amazed. Not only because I have never heard any of my professors speak this way but also because I thought I was the only one who thought this way.
I have a very strict budget I keep myself on. I have even planned in months in advance. I have also set up two checking accounts. One for living expenses and one for emergency and play. At the end of each month when all the bills are paid if there is money left I transfer it to the play account. Now you might think this is mundane and fairly ordinary way to handle the situation but actually to ensure there is money to transfer, I challenge myself on a daily basis. Anytime I wish to spend my “pocket money” I equate that purchase with a future expense or pleasure purchase. This usually deters me from spending much along the way. Most months I am able to attain the goal of putting away an X amount of dollars. The amount of relief and pleasure I obtain from being able to pay for an emergency, go to dinner, take a trip well out weighs a few moments of “pain” that I feel during the month. And as a bonus I don’t have to worry about which living expense I am going to have to cut back on to meet unexpected obligations.
I am very excited about getting your book. I feel it will be well worth it, and yes it will be coming out of the play account.
Hmm I wonder if there is a chapter in it about “You don’t miss what you didn’t know you had to have”
I buy the more expensive eggs, just because I’d rather have the local, free range organic ones, chock full of omega-3′s. Plus, the yolks are so rich and golden. Sometimes you need to see somethings as “investments”; like investing in your health when purchasing healthy food. Just cut back on the things that you really don’t need.