The entertaining book “Dollars And Sense: How We Misthink Money and How to Spend Smarter” does not tell us all the things we could do if we had a little money. Instead, authors Dan Ariely, a professor of psychology and behavioral economics at Duke University in Durham, North Carolina, and Jeff Kreisler, a Princeton-educated lawyer-turned-comedian, shed light on common mistakes we make where money is concerned and why we make them.
This book delves into the complex forces at work behind the money matters that consume our time and control our lives, and reveals how they can improve our financial affairs.
“Why? Because our decisions about money are about more than just money,” the authors write. “The same forces that shape our reality in the domain of money also influence how we value the important things in the rest of our lives: how we spend our time, manage our career, embrace other people, develop relationships, make ourselves happy, and ultimately, how we understand the world around us.”
We all think we know what money is but perhaps do not fully understand the role it plays in our lives. Money has no value in itself but represents the value of the things we can obtain with it. The process seems simple: you decide what you want to buy, you pay for it and it is yours. However, most buyers do not take into consideration the opportunity costs: the alternative benefits that could have been enjoyed but were given up when making a decision.
Ariely recalls visiting to a car dealership and asking potential buyers what they would giving up if they bought a new vehicle. Few of them had an answer because most people are solely focused on what they want to buy.
“We almost always fail to fully appreciate alternatives. And, unfortunately, when we fail to consider these opportunity costs, the odds are that our decisions are not going to be in our best interests,” according to the authors.
Financial tools and services such as credits cards, mortgages, car-leasing agreements and students loans often cloud our understanding of the future effects of spending money.
We often forget that all things are relative. A striking example of this is the case of US department store JCPenney. In 2012, new CEO Ron Johnson ended the chain’s practice of deliberately inflating the initial price of its products, then marking them down so they appeared to be bargains – even though the reduced prices were actually the same as those offered by other retailers.
The new policy of setting this realistic, lower price to start with was fair and transparent – yet customers hated it. They felt cheated and betrayed and sales slumped. In one year, JCPenney lost $985million – and the CEO lost his job.
“Think about that: JCPenney’s customers voted with their wallets and they elected to be manipulated,” the authors write. “They wanted deals, bargains and sales even if it meant bringing back inflated regular prices, which is exactly what JCPenney eventually did.”
As another example of real versus relative value, we often do not mind paying more for a bottle of water on the beach while on holiday, mostly because psychologically we feel the extra cost is nothing compared with the overall cost of the vacation.
How does all this relate to our desire to avoid the pain of paying? This, the authors explain, is the pain we feel not when we spend money, but when we think about spending it. The more we think about it, the more painful it feels. If we consume a product while thinking this way, the pain of paying can deeply affect the entire experience, making it less enjoyable.
There are ways to avoid the pain of paying. One is to pay in advance. Then there is no worrying about our enjoyment being spoiled by paying at the time of consumption. However, advance payment is less economical since the money is gone and no longer accumulating interest.
Paying after consumption hurts less, which is one of the main reasons why credit cards are so popular. They take advantage of our desire to avoid the pain of paying – we are less likely to remember the amount we spend if we pay with a credit card instead of cash.
“Credit cards are like memory erasers from a science fiction movie, but they live in our wallets” write the authors, who point out that studies have found people are more willing to pay when they use credit cards and tend to make bigger purchases.
“In other words, credit cards and even just the suggestion of credit cards, influence us to spend more, more quickly, more carelessly, and more forgetfully than we would otherwise,” they write. “In some ways, they are like a drug that blurs our ability to process information and act rationally…Their effect is deep and worrisome.”
Another common mistake many of us make is that we overvalue the things we own. The true value is a function of the utility and opportunity costs. Throughout their book, Ariely and Kreisler show how we all make many financial decisions but often do not take the time to think them through. When we do not know the true value of something, we are particularly susceptible to suggestion and misleading information, and so make the wrong decisions.
The responsibility, therefore, lies with each of us to become aware of our ignorance and limitations, and to improve our money habits so that we save and spend smarter, allowing us to live better lives.