Rethinking Money for the New Year

January 1, 2011 BY danariely

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,


This column first appeared at http://www.deluxeknowledgeexchange.com

The 7 Habits of Highly Ineffective People

June 14, 2010 BY danariely

The thing about habits is that for good and bad they require no thinking. An established habit, whether getting ready for work in the morning or having a whiskey after, is a pattern of behavior we’ve adopted—we stick to it regardless of whether it made sense when we initially adopted it, and whether it makes sense to continue with it years later.  From a human irrationality perspective this means that something we do “just once” can wind up becoming a habit and part of our activities for a longer time than we envisioned.

To get some insight into this process, consider the following experiment:  We asked a large number of people to write the last two digits of their Social Security number at the top of a page, and then asked them to translate their number into dollars (79 became $79), and to indicate if in general they’d buy various bottles of wine and computer accessories for that much money. Then we moved to the main part of the experiment and we let them actually bid on the products in an auction.  After we found the highest bidders, took their money and gave them the products we calculated the relationship between their two digits and how much they were willing to pay for these products.

Lo and behold, what we found is that people who had lower ending Social Security numbers (for example 32), ended up paying much less than people who had higher ending Social Security numbers (for example 79).  This is basically the power of our first decisions: if people first consider a low price decision (would I pay $32 for this bottle of 1998 Cote du Rhone?) they end up only willing to pay a low amount for it, but if they first consider a high price decision (would I pay $79 for this bottle of 1998 Cote du Rhone?) they end up willing to pay a lot more.

So this is the double-edged sword of habits, they can save us time, energy and unpleasant thinking, but on the other hand, it’s all too easy to start down an unwholesome path. Now onto “ The 7 Habits Of Highly Ineffective People”…

1) Procrastination. Joys untold attend this particular bad habit. And it’s one people indulge in all the time, exercise, projects at work, calling the family, doing paperwork, and so on. Each time we face a decision between completing a slightly annoying task now and putting it off for later, battle for self-control ensues. If we surrender, procrastination wins.

There’s nothing inherently wrong with delaying unpleasant tasks at work from time to time in order to watch a (crucial) football game at the pub with friends.  But, the problem is that as we get close to our deadline we start thinking differently about the whole decision.  As we stay up all night to finish a task on time we start wondering what were we thinking when we succumbed to the temptation of the football game, and why didn’t we start on the task a week earlier.  Moreover, as with all habits one procrastination leads to another and soon we get used to watching deadlines as they zoom by.

2) The planning fallacy. This is more or less what it sounds like; it’s our tendency to vastly underestimate the amount of time we’ll require to complete a task. This hardly needs illustration, but for the sake of clarity, recall the last time you delegated time to a complex task. Cleaning your flat from top to bottom (couldn’t take more than two hours right? Wrong.); finishing the paper or project at hand (who knew the people in department X could be so impossibly slow?). The problem is that even if we try to plan for delays, we can’t imagine them all. What if the person you’re working out a deal with gets hospitalized? What if an important document gets deleted or lost? There are infinite possible delays (procrastination of course being one of them), and because there are so many, we end up not taking them into account.

3) Texting while driving. Let me start by saying that in my class of 200 Master’s students, 197 admitted not only to doing this regularly, but also to having made driving mistakes while doing so. Also, one of the three abstainers in the class was physically blind, so we should not really count him as a saint, and who knows maybe the other two were liars. Texting while driving is clearly very stupid.  If we were not intimately familiar with our own Texting behavior, we might think that it’s insane to think that anyone would knowingly increase their chances of dying 10 fold rather than waiting a few minutes to check email, but this is the reality.  Moreover, the issue here is not just Texting, it is much more general than this particular bad habit.  The basic issue has to do with succumbing to short-term desires and foregoing long-term benefits.  Across many areas in our life, when temptation strikes we very often succumb to it (think about your commitment to always wearing a condom when you are not aroused and when you are).  And we do this over and over and over.

4) Checking email too much. If it seems that there’s too much about email on this list, I assure you, there isn’t. Checking email is addictive in the same way gambling is. You see, years back the famous psychologist B.F. Skinner discovered that rats would work much harder if the rewards were unpredictable (rather than a treat every 5 times they pressed a bar, one would come after 4, then 13, etc). This is the same as email, most of it is junk, but every so often, it’s fantastic: an email from the woman you’ve been chasing for instance. So we distract ourselves from work by constantly checking and checking and waiting to hit the email jackpot. And to be perfectly honest, I’ve checked my email at least 30 times since starting writing this article.

5) Relativity in salary. The fatter a sea lion is, the more sea lionesses he has in his harem. He doesn’t need to be immense, just slightly bigger than the others (too fat and he won’t make it out of the water). As it turns out, it’s the same for salaries; we don’t figure out how much we need to be satisfied, we just want to make more than the people around us. More than our co-workers, more than our neighbors, and more than our wife’s sister’s husband.  The first sad thing about our desire to compare is that our happiness depends less on us, and more on the people around us.  The second sad thing is that we often make decisions that make it harder for us to be happy with our comparisons: Would you prefer to get a 50,000 pound salary where salaries range from 40,000-50,000 or a 55,000 pound salary where they’re between 55,000-65,000? If you’re like almost everyone, you’d realize that you would be happier with the 50,000 pound salary, but you would pick the 55,000.

6) Overoptimism. Everyone, except for the very depressed, overestimates their chances when it comes to good things like getting a raise, not getting a divorce, parking illegally without getting a ticket. It’s natural—no one gets married thinking “I am so going to be divorced in 4 years”, and yet a large number of people end up getting divorced.  Like other bad habits, overoptimism is not all bad.  It helps us take risks like opening a business (even though the vast majority fail) or working to develop new medicines (which take many years and usually don’t pan out). Ironically overoptimism often tends to work out well for society (new restaurants, cures for disease) while endangering the individuals who take them (financial ruin, stress-induced insanity).  Sadly we are often overoptimistic – my most recent example of this was just a few hours ago when I sat down to write an essay entitled: “The 7 Habits Of Highly Ineffective People.”  If I only didn’t go out last night…..

Irrationally yours