Ten Money Mistakes to Avoid
Book Review:
Dan Ariely and Jeff Kreisler, "Dollars and Sense: How We Misthink Money and How to Spend Smarter", Harper, 2018.
If you are familiar with the research on cognitive heuristics and biases, then you have probably heard of Dan Ariely -- the Duke professor who founded the Center for Advanced Hindsight and wrote a number of bestsellers including "Predictably Irrational", "The Upside of Irrationality" and "The (Honest) Truth About Dishonesty". His latest book is a collaboration with the comedian Jeff Kreisler, who speaks a lot on the topic of money. It is called, in a punny way, Dollars and Sense (although there is also a British edition titled Small Change: Money Mishaps and How to Avoid Them).
In the Introduction, the authors emphasize the relevance of a book like this: we all think about money on a regular basis because it touches most aspects of our lives. Yet by thinking about it, we don't necessarily make good decisions. For example, we are willing to pay more when we use credit cards as opposed to cash; we don't save enough for retirement; and we spend more time trying to save a few cents on gas (petrol) than on finding a cheaper mortgage. Thinking about money can also lead to stress and unethical behavior. While financial literacy can help, Dan Ariely and Jeff Kreisler take a different approach in Dollars and Sense -- they focus on common money mistakes and why we make them. It is, therefore, a behavioral economics approach.
The book's eighteen chapters are divided across three parts: I. What Is Money? II. How We Assess Value in Ways That Have Little to Do with Value; and III. Now What? Building on the Shoulders of Flawed Thinking. In the first three chapters, Ariely and Kreisler explain how we would think about money if we were rational. Money does a lot of things for us, because it is (i) a general medium of exchange; (ii) divisible into any size; (iii) fungible; and (iv) storable. This means anyone can use it for almost anything. But therein lies the complexity of making decisions about money, because every time we make a choice, we need to think about which alternatives to sacrifice! When you spend $1 on an orange, you cannot spend that dollar on anything else now or in the future. The things you give up are your opportunity costs -- and this is the key concept to consider when making decisions.
Unfortunately, we don't naturally think of alternative ways to spend our money. At the core of the book is the thesis that we misthink money because we assess value in ways that have little to do with actual value. Ideally, value should be a reflection of opportunity cost: "What am I willing to give up for this?" In reality, we follow all kinds of irrational cues, which are discussed in chapters 4 to 13.
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| The illustrations in the book are by Matt Trower. |
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So here are the ten money mistakes to avoid, plus some tips on how to avoid them.
1. Relativity: We forget that everything is relative, and that sale prices are only "savings" relative to the original posted price. JCPenney used to artificially inflate its prices so that it could offer customers "bargain deals" through discounts and coupons -- and customers preferred it this way, because after the CEO switched to a policy of fair-and-square pricing, the store chain was losing money and had to fire the CEO! Logically, a $60 shirt is worth the same as a $60 shirt that was discounted 40% from $100, yet we can't help comparing the $60 to $100 (because it's an easy, albeit irrelevant, comparison). Relativity can also steer us toward the middle option in a range. It can even make us unhappy when comparing ourselves to more successful friends. At least for money matters, one tip is to avoid thinking in percentages; use the dollar value instead (because saving $20 on a $60 pair of sneakers isn't better than saving $20 on a $1,060 set of patio furniture). When buying a house or car, judge each item in the bundle separately. And compare that $60 shirt to all the other things you could buy with the same money.
2. Mental accounting: We compartmentalize and classify our money based on where it came from and how we feel about it. For example, you might set a monthly budget for entertainment, groceries, clothes, home repairs, medical expenses and so on. This can actually be a useful tool, as it simplifies decisions and helps control spending. The problem is that mental accounting isn't technically rational, because money is fungible -- i.e. a dollar from one account is interchangeable with a dollar from another account. What matters is the entire pool of "your money" and all the opportunity costs of a transaction. The way we categorize our money has side-effects: for example you might prefer to spend your salary on "serious" things (like paying the bills) while spending casino winnings on "fun" things (like ice cream and jewelry). You might spend a $12,000 lump sum differently than if you received $1,000 per month for a year. So, be extra careful when you find yourself temped to splurge using money from your "bonuses" account -- remember that it's just money. At the same time, given our cognitive limitations, mental accounting can be useful if used correctly.
3. The pain of paying: We wish to avoid it. We want easy payment. That's why we enjoy something more if we already paid for it in advance (or will pay for it much later). Credit cards, e-wallets, automatic billing etc. are payment methods that help lower the pain of paying... but in doing so, they also make us pay less attention to the costs and benefits of our transactions. The pain of paying also leads us to choose FREE! items even when they aren't necessarily the best. As Ariely and Kreisler write, free is "a price that disproportionately grabs our attention" (p. 225). What to do? Well, the first step is to be aware of one's pain-evading choices; the next step is to embrace some pain, for example by paying with cash instead of credit card.
4. Anchoring and herding: We trust ourselves to make value judgments but often base these on the first price we see or the previous price that we paid for something. For example, the value of a house might depend on its quality, size, nearby schools, or even market conditions and prices of competing houses, but it should not be influenced by the listing price of the house. Yet studies show the listing price does influence real estate experts' estimates of the value, even when they deny that it does! This is an example of anchoring, whereby an irrelevant piece of information pollutes our decision-making process. Especially when it comes to first impressions, we tend to trust our instincts and stick to an anchor. We also tend to trust the opinion of the crowd -- this is known as herding. When we trust our own past decisions, this is called self-herding, and it's related to the confirmation bias in that they both work to reaffirm our previous decisions. Through the mechanism of arbitrary coherence, anchoring is related to relativity, as the starting point might be random but subsequent decisions within the category will be evaluated relative to the prior ones. A remedy is to stop and question your long-term habits, and to question the MSRPs (manufacturer's suggested retail price) set by companies.
5. Loss aversion: We overvalue what we have due to the sense of ownership called the endowment effect. The owners of a house might list it for a price that buyers aren't willing to pay, because buyers and sellers actually disagree about what something is worth -- especially when the sellers have fond memories of it and have made "wonderful" changes to it. The investment of effort plays a role in this, and has been dubbed the IKEA effect since the labor we put into assembling an IKEA nightstand can give us a sense of pride and attachment. Furthermore, the principle of loss aversion says that we feel the pain of a loss twice as strongly as we feel the pleasure of a gain. This irrationality leads people to turn down free money from company-matched retirement funds, or to sell winning stocks too quickly. It also makes people throw good money after bad, as they find it hard to ignore what they already invested (this is the sunk costs fallacy). To overcome these biases of ownership, try to separate yourself from the things you own, and focus on the future rather than the past. When renovating your home, beware that your taste may not be shared by others. And beware low-cost trial offers that marketers use to hook you.
6. Fairness: We worry about fairness and effort, and whether someone appears to have worked hard when they charge a high price. Logically, you should be willing to pay a price if you think it reflects the value of the product or service to you... yet people seek to punish the unfairness of high prices for things that look easy (even at cost to themselves!). As Ariely and Kreisler put it, we are "little brats who believe that prices should be fair" (p. 135). For example, we get outraged when an umbrella that usually costs $5 suddenly costs $10 on a rainy day, when a locksmith charges us $200 to unlock our door in two minutes, or when an Uber ride costs much more during a snowstorm. But according to supply and demand, such prices can efficiently provide good value (like getting home dry). When we emphasize observable effort over the outcome of having our door open, we are actually paying for the incompetence of slower locksmiths. So, remember that experience, expertise and knowledge (which are often less visible than effort) also matter. At the same time, beware of false effort; unscrupulous folks can use it (and call it "transparency") to take advantage of you.
7. Consumption vocabulary: We believe in the magic of language and rituals, such that what we do at the time of consumption and the words that describe something can affect the value of our experiences. For example, the same bottle of wine may be "okay" when drunk from a mug in the office, but excellent when the sommelier at a French restaurant describes the "robust charisma" of the rare special grape harvest and the awards it won. Language influences what we pay attention to and how much we enjoy something -- and therefore how much we value it. Similarly, a ritual like swirling the wine and raising a toast can enhance the consumption experience by giving it meaning and making us more involved. Rationally, the language or ritual shouldn't change the product. But they do, and it is up to you to decide when you want to embrace the magic and buy an "artisanal hammer" and when you want to avoid paying for a long-winded description.
8. Expectations: We overvalue them --- i.e. our anticipations of the consumption experience can distort its true nature. Just like language and rituals, expectations can alter our experiences and therefore how much value we actually get. If we expect a product to perform better than its rivals, we are willing to pay more for it. Before the experience, we already start to anticipate and imagine. And during the experience, our prior expectations cause us to focus more or less on certain positive or negative aspects, thereby changing our subjective reality. This is why brand names and reputations matter. Should we rely on expectations? Well, Ariely and Kreisler suggest that we use expectations to our advantage to get more enjoyment, but avoid being unwittingly manipulated by someone else. As they say, "Don't believe the hype" and "Don't judge a book by its cover" (p. 220).
9. Self-control: We lose control and give in to the temptations of the present. We fail to save for retirement. We waste time on social media rather than exercising. In general, we find it hard to delay gratification because the present is much more emotionally involving than the hypothetical future. Additionally, (sexual) arousal, alcohol, fatigue and distractions can all lower our self-control and willpower. The problem of self-control means that even if you value something correctly, you may end up doing the irrational thing anyway. As for a solution, Ariely and Kreisler dedicate a whole chapter to that, which we'll get to in a moment.
10. Prices: We overemphasize money when comparing different products or experiences (because it makes things easier to measure). Hence heuristics such as "expensive = good", which partly explains why people enjoy pricier wines more. But when money is the default focus, we tend to ignore other dimensions such as happiness, relaxation, health, meaning, love... The point is to remember that money is just a means to an end. Perhaps a useful way to make the right trade-offs is to directly compare different opportunity costs, without involving money. For example, how would you balance vacation time against the number of movies you could watch instead? How about gasoline vs. new clothes? A new TV vs. dinner out with friends? A big house vs. a small house with a yearly vacation?
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In general: we tend to ignore opportunity costs. One way to combat this is to translate money into time: how many hours or months will you have to work to pay for something? You can also get a clearer picture of something's value by doing research -- go online and dig around before you buy that car!
Chapter 16 gives more advice on self-control: an issue that has garnered much attention on LessWrong under the term akrasia. Ariely and Kreisler say that we need to "reconnect to our future selves" (p. 228). One approach could be to have an imaginary conversation with or write a letter to your older self. You can make your retirement more concrete and defined by giving it a specific calendar date. Virtual-reality technology can help us interact with older versions of ourselves. These are all attempts to make the future more vivid, detailed and relatable. There are two additional kinds of approaches: (i) Ulysses contracts limit one's ability to give in to temptation, for example automatic savings plans; and (ii) reward substitution replaces a future reward with a tangible, immediate reason to do something painful, for example giving "lottery" tickets to people who deposit money into a savings account.
The authors also point out, in the next chapter, that spending smarter is not just a fight against our own mental tendencies, but also against various forces in the economy (i.e. mortgage brokers, financial technologies, car salesmen etc.) that constantly want us to spend more. So, the ideal solution would be to redesign the financial environment with human flaws in mind -- for example, developing apps that keep track of opportunity costs, or increase the pain of paying. We could even make the act of saving more visible (e.g. awarding stickers or trophies) in order to nudge social values. Of course, the aforementioned automatic savings plans are also relevant here. Ariely and Kreisler admit that not all their suggestions are equally practical, but say that the principles are starting points.
Finally, in Chapter 18 the authors reiterate the need to stop and think. We need opportunities to reflect and consider what we're doing, especially for big decisions that have the potential to cause long-term harm, or habits that add up to a large cumulative impact. We should talk to our friends about money and help each other. Here, the tips from the Heath brothers' book "Decisive" might come in handy.
So, there you have it. Consider the alternative things you could buy with your money; translate money into time; do your research before buying something expensive; think in dollar amounts instead of percentages; look out for possible anchors; prefer cash over credit card; be extra alert around FREE! stuff and package deals; let go of sunk costs; don't place too much importance on transparent effort or fancy descriptions; sign up for automatic savings or pension plans; imagine vividly what your desires and regrets will be when you're 70; pause occasionally to question your long-term habits; and use mental accounting responsibly.
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I've noted in my review of "The Black Swan" that Nassim Nicholas Taleb supports the approach of making society robust against the errors of humans, rather than trying to fix human nature or eliminate randomness. It seems that Dan Ariely and Jeff Kreisler follow in a similar spirit when they promote a "peaceful coexistence with money" (p. 257) where we "don't question everything" (p. 256). Indeed, in the discussion on language, rituals, and expectations, the authors argue that "... because we are humans and not robots, it's hard to say that language, rituals, and expectations should never influence us. ... especially when they provide an enhanced experience" (p. 215). They get even more philosophical:
"What is reality? Is it the objective taste of wine as a robot would taste it, or does the taste include our expectations and all the psychological influences around it? In truth, both are realities." (p. 221)The point is, of course, is to use expectations as we choose to use them after being well-informed, rather than being used by expectations. Likewise, many of the positive tricks in the book take advantage of our quirks -- for instance, sorting your money into multiple envelopes and writing your children's names on them has been experimentally shown to decrease spending (since you'll feel guilty). This approach is markedly different from the one espoused by Eliezer Yudkowsky in the Sequences; for example, Yudkowsky has argued:
- "Biases are lemons, not lemonade, and we shouldn't try to make lemonade out of them -- just burn those lemons down." (Lotteries: A Waste of Hope)
- "What if self-deception helps us be happy? [...] There is no second-order rationality. There is only a blind leap into what may or may not be a flaming lava pit. Once you know, it will be too late for blindness." (Doublethink)
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Dollars and Sense is a funny book and entertaining to read. Perhaps this is unsurprising, given that one of the co-authors is a comedian. In Chapter 16, for example, they suggest the following remedy for self-control problems:
"Ulysses was tied to the mast. What if we took that binding and punishment further and created a discipline bank with a dominatrix as a logo? This bank would take every possible money decision out of our hands. [...] If we overdrew or otherwise violated our preset guidelines, we'd get punished, because we'd have been naughty, naughty." (p. 233)So, the book definitely has a lighthearted character, but at the same time it does include descriptions of experiments by psychologists and behavioral economists. Some of these will be familiar to the reader having read Dan Ariely's "Predictably Irrational" -- there is the famous Economist magazine subscription experiment (to illustrate relativity), and the experiment where students who received free mugs valued them at twice as much as the students without the mugs (endowment effect). Indeed, multiple reviewers of Dollars and Sense have noted that much of the content overlaps with Ariely's previous books. The topics of relativity, anchoring, the endowment effect, self-control, and expectations are all covered in Predictably Irrational. However, it seems that some topics from the latter (e.g. social vs. market norms) are not present in Dollars and Sense and vice versa, some topics from Dollars and Sense (e.g. mental accounting) are absent from Predictably Irrational.
Besides that, Dollars and Sense is also written in a different style. Each chapter begins with a short vignette -- a story that illustrates the topic of the chapter in a way that is meant to be relatable. There are characters like "Aunt Susan", "Cheryl King", "George Jones" and others. The authors then ask: what is going on here? (Then follows the explanation.) The chapters are divided into sections with amusing titles, some of which are puns and some of which are subtle references. Here are some examples of headings:
- A JCPenney for Your Thoughts
- A Rose by Any Other Name Would Still Cost Us More
- You Sunk My Ownership
- Money Is Important and Foolish... and So Are We
If you want to read more about the irrationality that befalls people when they go shopping, you may like my article Shocking Shopping.
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