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 and retailers 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.
Next week, we’ll look at how loss aversion can mean you buy things you don’t really want.
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@textbooks and @Jean, thank you so much for the kind words! As to your question about splurging (and keeping in mind that I’m no expert in psychology), I believe that what is going on is the fact that buying something new activates the pleasure center in our brain. This is true even if you are on a strict budget and are worried about money. The purchase will give you a quick (and temporary) boost. This is why you see people who are “shopaholics”–they are always looking to get that boost, but it will never last.
I hope that answers your question, and I hope you enjoy the next three articles in this series. I find this stuff fascinating, too.
Self-control might be one way of putting it. For me, if I find I NEED an item, I will make an effort to inquire about where I can buy the best quality in the item for the best price.
I believe in value for money, (which seems to be partly what you expressed). Value for each of us is different and it also depends on how much of a need there is for an item (speaking in purely materialistic terms). For example, I may find I need a set of sheets. Is the need urgent? Can it wait? I want to buy quality and I want to look around for what is available and what price will match my value of the item. On the other hand, if I need a set of sheets urgently for a visitor coming to stay in a few days, I will be willing to pay half the amount of money for half the quality I would expect. After all, the sheets will not be used that often and will probably outlast the sheet I use all the time.
That said, I have walked into a shop browsing for a gift and spotted something which has immediately caught my attention and I have quite literally fallen in love with it and must have it. I have paid more for it than what the usual price may be for a similar item. I considered the value was in the aesthetics and the emotional value I attached to the item. I ‘loved’ it. It sits in my linen cupboard where I see it each time I open the cupboard and it gives me a psychological boost just seeing it. It cheers me! The item is a particularly attractive cushion with a bright design of geisha dancer. I don’t use the cushion, although I could. I don’t want to ruin it. The value for me is just looking at it. I don’t regret the money I spent on it and I didn’t need the cushion. I just love having it and looking at it, and I will probably give it to my daughter in years to come and hope she will get pleasure from it as I have.
I spoke to my sister about my uncharacteristic purchase and as she is a frugal person too, I expected her to frown and scoff, however, she said she made a similar purchase of a lovely rug which she saw and could not afford. Her rug also sits in her linen cupboard and she touches it each time she opens the cupboard and it gives her a psychological boost too. She said, I don’t need it and refuse to use it or part with it.
Interested in comments on this form of consumer behavior and money economics.
Excellent post. We are all very susceptible to price anchoring quite often. The example your friend used to equate the 56 Ramens to one CD is a good one. I often find myself doing that too whenever trying to justify shelling out a good sum for anything and soon I am able to rationalize that it was not a truly needed purchase.
-Jean
I LOVED this article! This psychological/behavior stuff is fascinating to me. I had never heard of anchoring, but it makes perfect sense to me. However, what about someone that likes to “splurge” (like going beyond one’s self-imposed spending boundaries) from time to time? I wonder what the psychology behind splurging is?
This may not answer your question entirely, but in economics and psychology, there is something called the ‘effort heuristic’ in which we may assign over estimated value on something depending on the amount of ‘effort’ that went into producing or acquiring that good. So for example if I won $100 in a bet, i would be more likely to go out and spend that money on whim or “splurge”, compared to if I had earned that $100 working. There was little effort required in winning that $100 so i feel i can go out and splash the cash!
When it comes to BXGO (it’s more common to see “buy two get one” where I live), I look at the total price spent and divide it by the number of objects that I’m buying, and then compare that unit price to the real unit price. If the numbers are significantly different (this depends entirely on what I’m buying–a 50-cent difference in shaving cream isn’t really worth it, though a 20-cent reduction means I’m stocking up on juice) then I buy it.
Saving money is what people think they do. Many people are happy when they buy something on sale for half price, thinking they saved so much on the purchase when in fact, they just spent money.
Self -anchoring is a form of self control. Another method: you split your wish-list into needs and wants. Unless all needs are fulfilled you cannot go to wants. And if something is not on that list it never gets bought.