Rethinking Money for the New Year
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 unintuitive 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?
Heuristically Speaking
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 turn 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 and paid a premium for the same coffee we could get elsewhere, we might continue with this strategy for a long time without reconsidering how much we are really willing to pay for coffee.
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 (and re-examine) every purchasing decision we make. But the advantage of examining our habits is that it might lead us to create better ones that will benefit us for a long time.
May you have a happy and exciting new year,
Dan
This column first appeared at http://www.deluxeknowledgeexchange.com
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This reminds me of Buridan’s ass, even though the options have different values!
Yuk, this seems like it would lead to total decision gridlock. Making every decision a separate project. It would take forever just to get through a day. If you apply this to money, you must also apply to time, an even more valuable commodity. Do I really have to rethink what TV show I want to watch Tuesday night? It would seems obvious that my existing rules and past decisions are ok, and don’t need to be constantly re decided. Maybe a seasonal reevaluation. Perhaps around the new year?
I think we should re-think “money” from how it is created. Many of our irrational behaviors are linked to the monetary system, for example, the architect of the euro said: “greed and competition are not a result of immutable human temperament; I have come to the conclusion that greed and fear of scarcity are in fact being continuously created and amplified as a direct result of the kind of money we are using”
Dan please check this article, the 11th round: http://www.lietaer.com/2010/09/the-story-of-the-11th-round/
The only possible way to cut costs is to not buy stuff
We all have an entire lifetime practicing buying stuff, so we should all be able to make these calculations quickly and with very little effort
Just a comment. In order to make a decision you just have to consider the second best purchase for the $1.75, not all the possible choices. I mean, make a long list of alternatives, put first the fancy coffee and compare it with the second best. have a great 2011
I’ve felt like the guy with the ‘which’ problem. Usually, feeling THAT tired and worn, any old dishwater swill will ‘hit the spot.’
The larger problem: silly habits. Yes, think and revise your decision. Most decisions we make are timely or time-bound. Situations differ, too, and are not often exactly equal. Answer the real question: What is best NOW?
In the world of teacher contracts- you see this type of thinking. Seniority rules of pay were created to combat pay inequities in the 1970′s however they still persist today. Reformers have forced teachers to readdress this question but if not for that perhaps seniority pay and rules would have continued in ad finem. In fact I might add an additional thought. Not only do we continue to repeatedly make the same decisions, but we adjust our “logic” in defense of our original decision in spite of context chages that might demand we change. In other words, I think in many instances we understand that context has changed, but we refuse to rationally reevaluate our orginal decision because we are in some way emotionally attached to it. So to change our minds and go to Dunken Doughnuts instead of the Gourmet Coffee shop, is to somehow admit our orignal decision was faulty. We have a kind of “pride” in our rationality- a pride that is irrational.
This reinforces what I was talking to with my friend who was wishing everybody a “Happy Resolutioning”, which made me think: re-solutioning – revisiting if the solutions of the past are still working and coming up with new ones if they don’t.
There are a couple of really fun stories in Watzlawick’s “Pursuit of Unhappiness” that are reinforced by your article.
The best financial aid it to make a budget that will let you live within your means. If in that budget, you can afford a fancy cup of coffee, then have it. If not-then don’t. That simple-have a plan and decide accordingly. The rest is mumbo jumbo.
The emphasis seems to be on how to deal with rationality, with all its faults. This suggests that if only we knew enough then we could decide perfectly, because it would be perfectly rational. This is, in my view, very far from a truth about the brain and about decision making. The idea that everything can be reduced to a scaling system with one line of ultimate value is nonsense. Money has been a part of the creation of that illusion. In the process of decision making we create value judgements about the minutiae at many different levels, and these are not all reducable. For example, in relation to the coffee, I need to include the chances of meeting new friends, the value of meeting new friends, the value of resting now and for longer against resting later when I am meeting other people, and so on. The ammazing thing about the brain is that it can, when it is working, make balanced judgements about anything and everything, and only when these are reduced to a small number of factors can they be said to be irrational. When the first intelligent machine is made it will need to be able to do the same kind of balancing of all and everything, and it will then be liable to the same charges of irrationality. Getting wise about money is about being sure to check on future value, which may be nothing like past value, and the uncertainty isn’t all about the world outside your head it is also about the world inside your head.
Interesting proposition. I think anchors play a big part in the valuation/comparison process. For example, when I first started going to the movies an anchor was set. Now paying almost $10 now seems ridiculous but my teenage daughter doesn’t give it a second thought.
On a relatd note, I’ve caught myself at times buy a Godiva chocolate bar thinking, “This is four times more than a regular Hearshey bar.” The irrational act was that I didn’t think Godiva tasted four times better and I still bought it…and might do so again.
Dan,
Thanks for this article. It actually contributed to the inspiration for a blog article I wrote regarding executive compensation and why companies pay what they pay.
http://www.compensationcafe.com/2011/01/executive-pay-and-the-emperors-new-clothes.html
As someone mentioned in another comment, another rational thought component is the effort it takes to constantly re-evaluate your prior decision. If you believe that your first decision was determined rationally, you may be willing to let that ride for a very long time (often too long) while you focus on other decisions.
In the case of a cup of coffee, you may only re-evaluate if your habit is to buy a cup every day, or if you free cash is being impacted. If you are a company you may only re-evaluate when the stock price starts going down, a scandal occurs or regulations change.
It would be interesting to under how much time and effort goes into each truly rational decision and how that time impacts the monetary savings or gain.
Hi Dan, good blog. On your last point, effort for a ‘truly rational’ decision am afraid the news is there is none. Read Jonah Lehrer How We Decide or watch him on The RSA web site. All decisions have an emotive trigger, and as to rational being the best anyway, read Gerd Gigerenzer’s book Gut Feelings. The review we need to carry out, methodically I would suggest, is tabular, in that we need to review rationality with reason, and with intuition, we need to review intuition with intuition with intuition and with reason, and we need to review these reviews with creative methods which challenge our beliefs and seek different ways of seeing and valuing things. We make loads of small evaluation errors but mostly we can say, well, what the heck. The terrible thing is we make some huge errors and then because of our ‘cognitive dissonance’ we seek to avoid being wrong by working hard to believe we are right, against all evidence to the contrary, and we do this by reframing our evaluations to suit the intended ‘rational’ outcome. Just as we test our theories about the development of physical apparatus through experimental method we also need to use a similar process to test our big decisions at work or personally.
Thanks for the insight Graham.
In today’s world, the praticality of conscientiously being aware of every money decision is overwhelming. As I sit at my desk it is costing, $20.00 per day for a leased office with phone and internet service and another $85 per day for a home with a mortgage,electricity and phone/internet service.Do you believe the average person analyzes finances to this level? This is overwhelming to me to think we have to be generating $105.00 per day in income just to cover these two expenses not to mention all the rest….Wow! How irrational is that!
Yes you do have to be very considering of your budget,
figure out how much that coffee latte costs everyday, enough for a vacation in a year !
Also , try getting a creidt card that gives you 3% percent cash back, what Im saying is every little bit helps.
Wouldn`t it be irrational to spend hours doing those calculations to determine how much to spend for coffee? Wouldn`t there be some higher utility activity you could do in that time?
Many thanks for writing this useful article..Liked your content. You should do sustain writing