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What Really Causes Your Money Choices?

Have you ever given thought to why car sales people want you to sit in the car and even test drive it when you are contemplating a purchase?  Why does a real estate agent want you to sit down in the kitchen or the family room of a house you are viewing?  Is it all planned?  Well, Yes it is!  Why?  This action is a part of every sales training program I have ever used.  It is a part of the touch it, feel it, buy it motivational effort sales people use to convince you (while you convince yourself) that this is what you want.  Here is an article I ran across that pretty much explains it.

Financial Tips from Emily Guy Birken

How Anchoring in Behavioral Economics Explains Your Irrational Money Choices

When it comes to making money decisions, we all like to think that we are rational creatures who will make the best decisions for our self-interests.  Unfortunately, much more goes into any decisions we make than a simple cost-benefit analysis.  Advertisers, retailers and well trained sales people have long understood the irrational impulses that drive consumers, and economists are starting to catch up.  That is where the (relatively) new field of behavioral economics comes in.  Where classical economists were once baffled by apparently irrational money decisions, behavioral economists look at the psychology of decision-making and can help us to understand the psychological barriers to making good money decisions.

One common way that your brain is fooled when making a financial decision is an effect called anchoring.  An anchor is a price point that gives you an idea of how much something should cost.  Suppose you go out for a nice meal with your family.  You want to order a bottle of wine for the table, but not knowing much about wine, you’re not certain what you should purchase.  You see that the wine list includes a $100 bottle of wine, so seeing the $50 bottle listed next to it seems like an incredible steal.

You have to ask yourself if that is really the case.  You probably would have been just as happy with the $25 bottle, but since you came into the situation without a clear idea of how much to spend, you’re likely to fall victim to the anchor price of $100.  Restaurants understand this effect very well, and will often only keep one bottle of the expensive wine on the premise.  It’s only there to sell the “mid-priced” wine, as no one’s really going to order it.

The trouble with anchoring is that it is very difficult to ignore.  Once you have a set price of something in mind, it can be tough to remember that the anchor you’ve been using might not have anything to do with a rational price you want to spend.  Even knowing about the process of anchoring and how restaurants, stores and advertisers use the process doesn’t necessarily make it easier to make a smart decision.  Case in point, when’s the last time you fell for a “buy-one-get-one-half-off” sale?  You probably spent more money than you intended to just because the second item seemed so much cheaper than the anchor item.

In order to combat the effect of anchoring, it’s important to put your own anchor to the amount of money you would otherwise spend.  A friend of mine did this when she was a poor college student and she thought of everything in Ramens (her go-to cheap meal which only cost $0.25 each) rather than dollars.  If she wanted a new CD, $14 might seem reasonable, but 56 Ramens (nearly two months of dinners!) was far more than she could afford to spend.  This type of thinking also made it possible for her to avoid the temptations of the bargain section, since a $5 album was still worth 20 meals to her — and she needed the food more than she needed the tunes.

Self-anchoring is an important exercise for all of us.  Take a moment to decide what $25 can buy you that you need or love to have.  Then you’ll be able to easily figure out if the $50 bottle of wine is worth giving up a night or two at the movies or a few trips to the doctor’s office when you consider your co-pay.  That kind of anchoring is much more rational, and it will help you save.

If you ever kept a gym membership long after it has become clear that you are not now and will never be a gym rat, then you have felt the effects of loss aversion.  This particular effect of behavioral economics explains why people are more likely to work to avoid a loss than they are to earn a gain.  Loss aversion is the wiring that makes us feel more depressed at the loss of $100 than elated at winning the same amount of money.  No, it’s not rational, but it does affect how you handle your money.

The Retail Effect

For example, ever wonder why retail clothing stores have those helpful bags and baskets for gathering all your potential purchases?  Retailers know that once you have held an item in your hand, you’re psychologically tied to it and you don’t want to give the item up.  The longer you have it in your possession, the stronger that connection, and the more you are unwilling to part with your new stuff.

Loss Aversion in the Stock Market

You will also see this effect very often in the stock market.  Investors will hold onto a tanking stock long after it is clear that the investment is dead in the water, because loss aversion makes it difficult to let go in fear that it might recover.  This is also the reason why people keep bread machines, treadmills and their college stereos around the house, as they hate to think of selling it at a loss. The ebay  business model was designed to help calm the potential perceived loss.  Even though something is worth more to you if you sell it for $5 at a yard sale, the perceived loss is a killer.

Avoiding Loss Aversion

Loss aversion is so deeply written into our psyches that it is extremely difficult to avoid, even though it is possible to watch others make irrational decisions based on loss aversion.  In order to combat the effect, it’s necessary to do a rational cost/benefit analysis of nearly every financial decision, which is difficult to say the least.  However, there are a few things you can do to combat loss aversion in various settings:

When you are out shopping, avoid picking up any items you don’t really want to buy.  It’s much easier to leave the cute purse or new gadget behind if you’ve never thought of it as “mine!”

When you’re offered a free trial period of anything, like HBO with your cable package, for example, just say no if it’s not something you’re currently willing to pay for.  The cable company knows you will be willing to pay more in three months to keep your fix going than you are to just buy it outright.  That’s why they offer the trial.

In terms of investments, automation of a sensible strategy will help to combat your loss aversion.  If you are not involved in the intimate details of each purchase and sale of a stock, you’re less likely to feel so psychologically tied to a particular decision.

Make Loss Aversion Work for You

Luckily, loss aversion can be a powerful tool for self-improvement, if you recognize how to use it.  Just as you don’t want to lose money, you don’t want to break a streak, either.  If you post a large calendar in your home and place a gold star or red X on every day that you do something you’re working toward, compose 500 words of the novel you’ve been meaning to write, refrain from smoking, do exercise, etc., loss aversion will keep you working on that streak once you have a decent chain of days going.  Your disappointment in seeing a day without a gold star is greater than your happiness at any single day’s work.  So use that psychological trick to keep you on track.

By: Emily Guy Birken, www.moneyning.com

So, now you know.  It takes practice to overpower and control the attempts by others to control your behavior in financial endeavors as well as other facets of your life.  Open your eyes, analyze and determine who is trying to do what to whom.