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

Want People to Save? Force Them

September 25, 2010 BY danariely

In Chile last June, I had the opportunity to spend some time with Felipe Kast, the new government’s minister of planning, and a few of his compadres. (We also went dancing, but that is another story.) One of the topics we talked about was the Chilean retirement saving plan.

By law, 11% of every employee’s salary is automatically transferred into a retirement account. Employees select their preferred level of risk, with the following restrictions: They may not choose either 100% equities or 100% bonds, and the percentage of equity that they can select diminishes as they age. When employees reach retirement, their savings are converted into annuities. The government auctions off the rights to annuitize retirees in groups of 250,000.

This brilliantly conceived approach solves thorny behavioral and institutional challenges. Behaviorally, it recognizes that people are not good at two aspects of financial planning for retirement—deciding to save and eliminating risk in later years—and it forces them to act in a better way. At the same time, the system acknowledges that people who enroll in retirement plans are reasonably good at managing their own risk. So investment choices are left to the individual, with limits on too-risky behavior, especially as a person ages, when bad choices can do irrecoverable damage.

Institutionally, Chile has cracked an age-old problem with annuities. It’s risky business to predict how long people will live, so insurance companies charge a high premium to cover that risk, which makes for an inefficient market. Annuities also suffer from an adverse selection problem, further increasing risk. (The classic example of adverse selection is health insurance: The healthiest people are the least likely to opt in, which increases the pool’s riskiness, making health care less appealing for insurance companies and policies more expensive for the people who want them.) By pooling the risk, the Chilean government makes annuities an attractive business with more competition and better prices. And since everyone is forced to annuitize, the adverse selection problem simply disappears.

I was impressed with this system and wondered how it would fly in the United States, where our own mandated savings program—Social Security—undergoes sporadic efforts to privatize it.

I suspect Americans would consider the Chilean system heavy-handed and limiting—a flagrant example of nanny-state control. You can force me to save money when you pry it from my cold, dead hands. Paradoxically, we happily accept deeply controlling (and expensive) regulation on our behavior in other areas with little thought or protest. Consider the strictures we allow on driving. Wear a seat belt. Drive this speed. Bear the cost of air bags. Pollute only this much. Don’t text while driving.

Why do we accept so much government intervention in driving but chafe when it comes to a few simple rules that would help us make better financial decisions? It’s probably not because we think we’re smarter about finances than driving. I think the reason has to do with our ability to imagine negative consequences. Car wrecks have a way of vividly communicating our incompetence as drivers and making the benefits of regulation crystal clear. Poor money management can carry similarly devastating consequences, but they are less readily apparent. Even in times of economic crisis, we don’t recognize our own bad judgment because people around us are in the same boat and we compare our fortune with theirs.

But the inability to see our own irrationality shouldn’t be an excuse to let it go unchecked. We need to analyze what people and markets are good at and what they’re not good at, and use those insights to improve our institutions. Chile’s approach to saving shows us that it can be done, and done well.

This post first appeared at HBR

Save your own life

June 26, 2010 BY danariely

What would you think if someone told you: Do the right thing because your life may depend on it. Or more accurately, that you better start making better decisions because it is a matter of life and death. This may sound like something an overprotective parent would tell their child) but in reality it’s the way most of us should start to think about our day to day decisions and their potential to lead to harmful habits and fatal consequences. It is hard to believe that this is true, but recently, researchers have done some interesting analysis on this topic and the results support the idea that personal decisions, and often fairly mundane ones, are a leading cause of premature death in the United States (and I suspect that similar numbers are also the reality in the rest of the developed world).

One of the most interesting analyses on the ways in which our decisions kill us is one by Ralph Keeney (Operation Research, 2008), where Ralph puts forth the claim that 44.5% of all premature deaths in the US result from personal decisions – decisions that involving among others smoking, not exercising, criminality, drug and alcohol use, and unsafe sexual behavior.  In his analysis Ralph carefully defines the nature of both the type of personal decision and what is considered premature death. For instance, dying prematurely in a car accident caused by a drunk driver is not considered premature in this framework because the decision to drive somewhere is not one that can logically be connected to the premature death. Unless, of course, the person who dies is also the drunk driver, in which case this counts as a premature death caused by bad personal decisions.  This is because the decision to drive drunk, and dying as a result, are clearly connected.  In this way you can examine a large set of cases where multiple decision paths are available (the drunk driver also has the option to take a cab, ride with a designated driver, or call a friend), and where these other decision paths are not chosen despite the fact that they won’t directly result in the same negative outcome (i.e fatality). As other types of examples, consider the decisions to smoke (when not smoking is an option), to overeat (when watching our weight is an option), or for people with long term medical conditions to skip taking insulin or asthma medication when these are important to their ongoing health.

Using the same method to examine causes of death in 1900, Keeney finds that during this time only around 10% of premature deaths were caused by personal decisions. Compared to our current 44.5% of premature deaths caused by personal decisions, it seems that on this measure of making decisions that kill ourselves we have “improved” (of course this means that we actually got much worse) dramatically over the years.  And no, this is not because we’ve become a nation of binge-drinking, murderous smokers, it’s largely because the causes of death, like tuberculosis and pneumonia (the most common causes of death in the early 20th century) are far more rare these days, and the temptation and our ability to make erroneous decisions (think about driving while texting) has increased dramatically.

What this analysis means is that instead of relying on external factors to keep us alive and healthy for longer, we can (and must) learn to rely on our decision-making skills in order to reduce the number of dumb and costly mistakes that we make.

The question then becomes how to help people become better decision-makers. Or at least better at making decisions where their health is concerned. If nearly half of premature deaths in the US can be avoided by making better decisions, it is clear to me that it would be worthwhile to spend much more time and effort to disseminate the knowledge we have gained in social science about the main ways in which people fail to make good decisions.  It is of course over-optimistic to expect that just helping people to see what mistakes they are likely to make will fix the problem, but personally I would be happy even if it only slightly reduced the number of catastrophic decisions.  The next step we need to take is to expand upon the research that examines what kind of methods encourage healthier decision-making and conduct much more research in areas that could help us limit our mistakes. For example, based on research about how people make different decisions when they are sexually aroused we might concentrate on providing comprehensive sexual education that teaches teenagers how to make decisions while in the heat of the moment.  Similarly, by understanding how people think we might be able to teach people to enjoy eating fruit and vegetables; how to make exercise part of their ongoing lifestyle; and develop effective smoking cessation programs. And it would also help to remember, in light of this, that every decision counts.