Can we trick ourselves into making better financial decisions?
The science of saving
Why do people resist saving money?
Saving for the future is a challenge that seems almost perfectly designed to trip up the human brain, which is evolutionarily hardwired to respond to immediate threats, not long-term scenarios. It’s human nature to favor smaller, short-term rewards, even over bigger future gains. Behavioral economists, who study the impact of psychology on financial decision making, call this phenomenon “present bias.” Some people are more vulnerable to its effects than others. When researchers at the National Bureau of Economic Research asked people if they would prefer $100 today, $120 in 12 months, or $144 in 24 months, about half of the study participants said they would take less money if they could have it immediately. “Our emotions, which drive us so strongly, are inherently not rational,” says Dan Ariely, a behavioral economist at Duke University. “Saving is about now versus later, concrete versus abstract, and we don’t do those well.”
Can that hardwiring be overcome?
Yes, but it’s not easy. Instead of working against human nature, researchers are studying how people can take advantage of their own psychology to make better financial decisions. One way to do that is to simply picture yourself as an old person. Studies have shown that people picture their future selves as strangers, making them more likely to stick that person with the bill for today’s purchases rather than pass on a hefty nest egg. In one study, researchers at New York University showed some of the subjects digitally altered photos projecting what they would look like at age 70. The participants who’d seen their older selves said they were willing to save twice as much money for retirement account as a group who didn’t.
What savings strategy works best?
Making it automatic. Behavioral economists consider the growing number of employers auto-enrolling workers in retirement plans to be one of the financial field’s greatest successes, because then people have to decide not to save. Beyond a 401(k), arranging for automatic savings transfers around payday, ideally to a separate account, is also helpful. By “pre-committing” to saving the money and stashing it elsewhere, you will be less tempted to spend it. “Anything you can do with your money where you’re automatically saving and not spending, without having to make the choice to do it, leaves you with more resources to make better choices later,” says consumer psychologist Kit Yarrow.
What role does budgeting play?
A big one, but it’s also subject to human foibles. About two-thirds of Americans don’t keep a budget, according to Gallup. “Your emotional brain responds to the word ‘budget’ the same way it responds to the word ‘diet,’” says Brad Klontz, a psychologist and certified financial planner. “The connotation is deprivation, suffering, agony, depression.” Reframe your outlook— including savings plans—in terms of what it will allow you to enjoy, whether it’s a vacation right around the corner or peace of mind in retirement. Milestones like birthdays, or even the beginning of a new week or month, are a great time to recommit to spending and saving habits because you’ll be motivated by what researchers call the fresh-start effect.
How can technology help?
A growing number of personal finance apps use behavioral economics principles to help users better manage their money. Digit, for instance, analyzes users’ spending patterns and squirrels away small amounts of money into a savings account when they aren’t likely to notice that it’s gone. Acorns employs a similar approach, taking users’ debit-card purchases and rounding up the amounts, investing the “spare change” into a diversified portfolio of stocks and bonds. EarnUp automatically sets money aside for loan payments every time the user gets paid, including for credit cards, car payments, and student debt. Ariely believes technology could play a huge role in transforming chronic debtors into savers. “Change comes not from the inside, but the outside,” he says. “If you want people to lose weight, give them a smaller plate. You have to change the environment.”