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.