Dan Ariely, a world-renowned behavioral economist from Duke University and a founding member of The Center of Advanced Hindsight, has spent his life researching the various forces that shape and influence human behavior—and why we so often behave irrationally. In his latest book, "Dollars and Sense: How We Misthink Money and How To Spend Smarter," Ariely gets personal—personal finance, that is.
In Dollars and Sense, Ariely explores why people are prone to making poor financial decisions—and how we can help ourselves to make smarter ones. Experian Editor-in-Chief Aaron Task sat down with Ariely to find out about the biggest ways we "misthink" our dough.
Watch the video below for the full discussion.
Mistake #1: Not considering the opportunity cost
Ariely says the concept of money is "amazing" when you really think about it. In a barter society, people have to assign a worth to everything they trade. Money makes the process a lot more efficient. "We created...this common good, money, and money is this layer in society that lots of things can be traded for," says Ariely. "It creates a situation where we can specialize, we can have efficiency, we can produce, we can save. [There are] lots of wonderful things about money." But with those wonderful things come complications.
"Because money can be substituted for so many things, it's unclear what we are giving up exactly" when we buy something, he says. "So money is wonderful, but also very complex. And because we can't think about money the right way, we don't think about opportunity costs." The right way to approach money, says Ariely, is to always consider the opportunity cost—that is, the benefit you could have received for something but gave up in order to get something else.
"There is a huge amount of stuff you could buy with money, and every time you buy a cup of coffee, you should ask yourself: What am I giving up?" he says. But people don't typically prime themselves to think that way.
For example, Ariely talked to consumers about to buy a new Toyota, asking them what they were giving up in exchange for the car they were about to buy."People had no answer, because they never thought about it," says Ariely, who pushed the consumers to answer in some way. But they still didn't get it, giving responses like ‘if I buy a Toyota, I can't buy a Honda.'
"People were substituting in the same time frame and in the same product category," says Ariely. "What they should have says is, ‘This is three weeks of vacation over the next three years and 17 lattes and 17 books' and all kind of intertemporal and cross-product comparison." But that kind of mind shift is hard to do, "because there are so many different things you could do, you don't think about anything specific. You don't think of any of them," says Ariely.
Mistake #2: Thinking about money in relative terms
Another money mistake we commonly make? Thinking about money in relative instead of absolute terms. Imagine, for example, that you're about to buy a nice $15 pen, but the cashier tells you that another store down the street is selling the same pen for $7, which would save you $8. "Most people say, let's save the money," explains Ariely.
But you probably wouldn't do the same with a more expensive item, he says. If you're in the market for a digital camera that costs $1015 and the cashier tells you the exact same items is $1007 just three blocks away, you're more likely to stick with the pricier item. "Your bank account doesn't care where your eight dollars came from, [whether] it came from buying a pen [or] it came from buying a camera. Eight dollars is eight dollars. You should contrast it with walking, but we don't," says Ariely. "Money is absolute. At the end of the day, you have eight dollars more or less. But we don't think about it this way."
Ariely also mentions a phenomenon known as "the pain of paying"—which is often why we spend more money on credit cards than we would in cash. "When you pay cash, you feel a bit of pain. Not physical pain, but...a bit of agony as you pay off the money. When you pay with a credit card, it's not really clear when you're paying, so you don't feel that same pain," says Ariely. "So [when] the timing of consumption and payment… coincide, we feel worse about it. And when they are separate in times, we feel better about it."
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