The Right (and Wrong) Way to Think About Money
Interview by Usman Hayat.
Leading behavioural economist and best-selling author Dan Ariely gives his two cents to the CFA Institute’s Usman Hayat
Usman Hayat: What is the ‘right way’ to think about money?
Dan Ariely: The right way is all about opportunity cost. Every time you buy something — a cup of coffee, a car, a house — you should be asking, ‘What am I giving up now, and in the future, for this act of consumption?’ Of course, an infinite number of possible other consumption choices exist. Comparing, say, apples to oranges is simple: Nobody has ever stood in front of a fruit bowl saying, ‘I have no idea which one I want’, because the opportunity cost is so clear: Do you feel like eating an apple or an orange? But with money, you’re likely to be thinking, ‘Should I buy that new bicycle now, or put the money into my retirement fund?’ That is a very difficult decision, because calculating opportunity cost is the key to answering it — and doing so is not humanly possible. Even if you tried to get a computer to simulate all of the various things you could spend your money on, it would be extremely difficult to figure out a true opportunity cost for each purchase you make.
Is ‘short-term vs. long-term’ the crux of the issue?
That is one of the things that makes financial decisions so difficult, because when you think about spending money now vs. saving for later, you’re looking at something concrete vs. something abstract. You want that bicycle now; and retirement seems so far away. Even if you could say to yourself, ‘This bicycle represents one entire month’s rent’, it’s still about ‘now vs. later’. Likewise, with food, we get tempted by what is around us at the moment, because of our present-focused bias.
When you think about spending money now vs. saving for later, you’re looking at something concrete vs. something abstract.
You have said we think about money in ‘multiple wrong ways’. Please describe a few others.
One of them is relativity. Imagine you’re going to buy a car. The cost is 30,000 Euros, and the salesperson says, ‘Hey, would you like leather seats for an extra 2,000 Euros?’ Compare that decision with the following: You’re buying a chair for your house, and it costs 500 Euros. The salesperson says, ‘For 2,000 Euros more, you can get it in leather’. In the first case, you would likely think it seemed like a good deal; but in the second, you’d think it was a terrible idea — even though you sit down much more at home than you sit in your car. Because of diminishing marginal returns, the moment you spend 30,000 Euros, 2,000 looks like a small amount; but when you’re paying 500 Euros, 2,000 more seems almost immoral.
Another example is, we tend to not think about decisions from scratch. Instead, we do what is called anchoring, which means we consider our past decisions, assume that they were reasonable, and repeat them. Yet another strange bias affects housing. Obviously, buying a house or condo is a huge decision. To get an idea of what they can afford, people often use an online calculator. Then, they use the number generated by this calculator as the true amount they can afford. Just because you’ve used an online tool, it doesn’t mean you should borrow the maximum amount! Yet we have this idea that, ‘the calculator said this amount is okay’. As a result, lots of people end up buying a home that they can't truly afford — and that, of course, affects other areas, like saving for the future.
Is it possible to correct our behaviour and move from irrationality to rationality?
The question is, What tools can we give people to help them think better about money? If we still believe the human brain is designed to recognize opportunity cost — and that, if we leave people to their own accord, they will do the right thing, that will not happen; but if you admit that people are going to make some predictable mistakes, you can look at how chequing and savings accounts are structured — and come up with mechanisms to help people.
What would be an example of such a tool?
One example might be an ‘electronic wallet’ that nudges you to think about some of the things you want to purchase in the near future. Imagine if — just before you walk into Starbucks — it says to you, ‘If you keep spending money on lattes, you will not be able to afford that trip to Paris’. That would be one way to get people thinking about opportunity costs.
Or, imagine that your chequing account didn’t just include one total pile of money, but was divided into different monthly expenditures. When our salaries come in at the end of each month, we feel like we have a lot of money; but the fact is, rent is due tomorrow and that student loan payment is due the next day; so, you don’t really have all that money. Imagine that your account showed you how much money you actually have available to spend on discretionary things each month? Tools like that would be very helpful to people.
How can behavioural insights help finance professionals make better decisions on behalf of clients?
Professional investors are human, too, so they are susceptible to some of the same biases as everyone else. In 2008, we saw lots of institutional investors panicking and behaving in terrible ways — it was not limited to individual investors. So, understanding the role of emotions and decisions is centrally important for companies, as well as for individuals.
Think about something like dieting. You know full well that if you have your favourite cookies at home, you will eat too many. So, you might decide, ‘No more cookies at home!’ You might be willing to limit your freedom to eat cookies by doing that. Imagine if we took a similar approach with investments, and created a rule that ‘investors are not allowed to sell things immediately’. Instead, they have to go through a multi-step process that takes one full month — so that they can’t act on their emotions. We could apply that to any arena where emotions come into play and get the best of people, and find ways to stop it. The fact is, we will never reach perfect rationality, but we can do much better.
Dan Ariely is the James B. Duke Professor of Psychology and Behavioural Economics at Duke University, the founder of The Centre for Advanced Hindsight and the co-founder of BEworks. He is the author of several best-selling books, most recently, Payoff: The Hidden Logic That Shapes our Motivations (Simon & Schuster/ TED, 2016). This interview was conducted by the CFA Institute’s Usman Hayat.
This interview originally appeared in 'The Behavioural Issue (Spring 2017) of Rotman Management magazine.
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