Over the years I’ve discovered that knowing how to manage your money is only 20% of the picture. The biggest part, by far, is the mental battle.
If I could sit down with you for 1 hour, I could teach you everything you need to know to budget your money, pay off debt, invest and save for retirement. It’s not conceptually difficult.
What is difficult is living out that plan over the next year and the next 5 years and the next 20 years.
A Cash Based Budget
To help fight the mental battle, myself along with a number of other financial advisers recommend that you use a cash based system to manage your discretionary income.
Why? Using cash is a lot more inconvenient than just using your debit or credit card. Is there a reason to
The reason is that paying for things in cash has a profound psychological impact.
Understanding Loss Aversion and Prospect Theory
I’m going to offer you a bet. Imagine that I have a coin here. It’s a normal coin with a 50% chance of landing on heads and a 50% chance of landing on tails.
If it lands on tails, you have to pay me $10. But if it lands on heads, I’ll pay you $11. Would you take the bet?
What if I paid you $12? What about $15? Would you take the bet then?
A number of studies similar to this have been done in the real world. On average, I would have to offer someone $17.50 before they would take the bet.
It’s a bit ridiculous. Rationally, I should only have to pay to $0.01 more than you stand to lose. Assuming the coin flip is done enough times, there’s no way you could lose. But people don’t see it that way.
Losing hurts more than winning feels good. This is loss aversion.
This idea is expanded further in Prospect Theory
Daniel Kahneman, a psychologist and Nobel laureate, and Amos Tversky, a cognitive and mathematical psychologist, developed Prospect Theory in 1979 (winning a Nobel prize for Kahneman). This behavioral economic theory describes decisions between alternatives that involve risk, where the probabilities of outcomes are known.
Essentially it drills into the issue that humans are not rational decision makers. We tend to make decisions based on the magnitude of our potential gains and losses giving little regard to the probability of those outcomes.
Like the in coin flip bet above, the amount to be gained when taking a chance must be disproportionately larger than the amount to be lost even though each possibility has a 50% chance of occurring.
The Psychology Of Making a Purchase
Loss Aversion and Prospect Theory directly apply when you consider making a purchase.
In 2010, behavioral economists at Carnegie Mellon University developed what they call the Tightwad-Spendthrift scale. It tries to explain how consumers value a product, e.g. I’ll pay $10 for a pizza, but I won’t pay $100.
George Loewenstein from Carnegie Mellon and Brian Knutson from Stanford decided to do an experiment to understand what is actually happening in the brain when a consumer makes this decision.
They took a group of college students and gave each $40 to spend on an array of items from a George Foreman Grill to a sonic power toothbrush to the Dodgeball movie on DVD.
They placed each student in an MRI. The researchers would show them a picture of one of the items and watch their brain activity. They would then show the student the price of the item and watch how the brain activity changed.
Here’s what they discovered.
There are two important parts of the brain that we use when making a buying decision, the nucleus accumbens and the insula.
The nucleus accumbens is the part of the brain associated with reward and pleasure. Some have called it the area of sex, drugs and rock and roll.
When each student was shown a picture of an item they really wanted, the nucleus accumbens would light up. The more they wanted the item, the more active this area of the brain was.
Now, when they showed the student the price of the item the insula became active. One of the insula’s many functions is judging the degree of pain that you are experiencing.
In the study, the researchers came to the point where they were able to predict with a very high level of accuracy whether someone was going to buy an item based on the relative levels of activity in these two areas of the brain.
If the activity in the nucleus accumbens was greater than the activity in the insula, the subject would purchase the item more often than not. On the other hand if the insula was more active they almost never bought the item. The pain of paying for the item was greater than the perceived pleasure the item would bring.
Here’s Where Credit Cards Trick Your Brain
These researchers theorized that they would be able to induce more people to purchase an item if they could minimize the level of activity in the insula.
They found they could do this with credit cards.
When paying with a credit card, activity in the insula was reduced. The brain didn’t quite understand what was happening when the purchase was made with a credit card.
When you pay with cash you’re giving up something tangible to purchase an item. You are losing something (your cash) to gain something (your purchase.)
In order to make the purchase, your perceived gain must be substantially higher than the perceived loss.
Thus, when you pay with cash you are far more likely to make fewer purchases and will spend less money. The pain of the cash leaving your pocket hurts more than the pleasure you would get from making a particular purchase.
Companies Take Advantage of This
20 years ago a business that didn’t accept credit cards wasn’t that unusual. Today, it’s very rare to come across a store that doesn’t accept credit cards.
Moreover, a lot of stores are pushing new technology to make paying even easier – things like key fobs or smartphone apps.
Why are they doing this? Because they want it to be as painless as possible when you pay. They want to quiet your insula so that you feel the pleasure associated with the purchase without the pain of paying for it.
They also do this with their advertising. What’s Wal-Mart’s tagline? “Always Low Prices!”
They’re telling your brain – “Oh don’t worry if that item is a good value. Our prices are always low!”
You see similar things in marketing and advertising all the time.
Always Pay With Cash
Don’t allow clever marketing or the excuse of convenience to trick your brain. Paying with cash blocks out nearly all of this.
You’ll make far fewer impulse purchases and you’ll find that you have a much easier time sticking to your budget when you pay with cash.