How to Outsmart your brain against ‘Psycho’ Money Traps

I got the following information in one of Yahoo’s article and I found it interesting. It has been summarized to include only the interesting (to me) part. At the bottom of this post is the link for the full article.

Apparently, when dealing with financial matters it turns out there’s a lot of psychology and evolutionary history involved in why and how we do dumb things with money. We simply need to understand the most typical financial/psychological traps, then shift the way we make certain investing and purchasing decisions.

1. The lure of ‘free’

No matter how smart you are, that one little word can lure you to make

purchases you wouldn’t have otherwise.

The one simple word called "free" also explains why consumers will choose a "free" credit card (no annual fee) with an annual interest rate of 15 percent over a card with a $100 annual charge but a lower interest rate of 12 percent.

How to outsmart your brain:

"Whenever you see the term ‘free,’ consider it a warning to slow down and consider your choice very carefully," says Ariely. Do the math and always consider what you are giving up when you choose the item attached to something "free." Usually — but not always — there is a real cost to something touted as "free."

2. The ‘anchor-price’ persuasion

Study the following examples:

  • A real estate agent shows you two expensive homes first, then introduces you to two cheaper ones? The less expensive ones now seem like bargains, comparatively.
  • When you shop for a new TV, the price of the first one you seriously consider will be the price by which you compare all new TVs.
  • Similarly, when people move to new cities, they tend to compare home prices to what they paid for a house in their previous city and spend the same amount.

Thanks to a mental trick called "anchoring" for this habit. Our brains naturally latch on to the first price we see in a new-to-us purchase category — thus creating an "anchor" against which we compare all other prices. "This natural process helps us bypass the difficult decision of deciding what something new to us is worth" according to Dan Ariely, the James B. Duke Professor of Behavioral Economics at Duke University and author of "Predictably Irrational: The Hidden Forces That Shape Our Decisions.

How to outsmart your brain:

  • In the case of a house, rent in a new city for a year, until your brain adjusts to home prices in your new city.
  • In the case of new-to-you items, don’t buy in the heat of the moment just after you find "bargain" items. Wait and consider your purchase for a while. Give your brain time to decide whether the "cheaper" TV is really something you want to afford.

3. The instant-gratification attraction

We all know we should save for future goals like vacations, college and retirement, but many of us still don’t. Why?

  • Because, "you feel that you need a cup of coffee and, by the way, that pair of shoes is to die for. So you spend the four bucks at Starbucks
  • or you buy the new shoes, because both kinds of spending give you the intense pleasure of an immediate reward — especially if you pay with a credit card,"

What about that longer-term goal? It carries no emotional kick whatsoever. What’s rewarding about setting money aside today for a goal two or three decades away?

How to outsmart your brain:

Infuse your future goal with emotion. Visualize that next vacation in Europe or that retirement cottage you’ve been planning in Mexico in as much detail as you can.

4. The dollars-to-donuts decoy

Consider this classic economics puzzle.

  • You go to a store to buy a $100 lamp. You then learn that the same lamp is on sale for $50 at another store a mile away. Would you drive one mile to save $50?
  • Now imagine you’re considering a dining room set for $5,000. You learn that the identical set is selling for $4,950 at a store one mile away. Do you make the drive?

Hopefully you said yes in each situation. However, many people say no, they would not make the effort in the second example. Why? Because 50 percent of $100 ($50) instinctively seems more valuable than 1 percent of $5,000 (also $50).

How to outsmart your brain:

Don’t confuse dollars and donuts. Constantly remind yourself that a dollar is a dollar — just because it’s a small percentage doesn’t mean it’s not still real money. Ask yourself: Would I be willing to go to a different store to buy this item if they were handing out $50 bills (or whatever the savings would be)? Picturing your savings in cash makes it seem more worthwhile.

5. The separate-buckets blunder

For the sake of simplicity, most of us tend to separate our money into different mental "buckets."

For example, "Maintaining a credit card balance (Bucket No. 1) which may accumulate over a period of time even though you have more than enough liquid assets (Bucket No. 2: nonretirement money market funds, savings accounts) to pay off the balances,"

How to outsmart your brain:

  • Remind yourself that "money is money" — no matter where it comes from or what category you’ve placed it in.
  • Don’t spend your tax refund on something you wouldn’t buy with your monthly salary just because you think of it as "free" money.
  • If you get a $25 gift card from your grocery store for switching your prescription to their pharmacy, don’t automatically use the card for something frivolous. Buy the same items you would have purchased if the $25 had been cash from your own wallet.

6. The ‘sacred-fund’ slip-up

This one also falls into the category of "mental accounting."

Studies show that many folks would be uncomfortable risking Grandma’s hard-earned money, so they treat inheritances much more conservatively than their other cash. The same is often true of our workplace retirement money. We mentally consider it "precious retirement money" that we’re afraid to lose, so we put it in more conservative accounts than we really should.

How to outsmart your brain:

  • Deposit gift money into the same account as your other savings and let it sit, commingled with your other funds, until it no longer feels separate from your other money. Over time, you’ll begin to treat it as you would your own earned money.
  • As for retirement accounts, consider putting just a portion of the retirement funds into investments just a little riskier than usual. This should be true especially in cases in which you get a match from your employer, in which case you’ve already earned a 100 percent return on your money just with the match.

7. The lost-money fallacy

Once we own something — a house, an investment stock, a car — we often irrationally keep it or even put more money into it, even when it’s time to walk away.

Example: You continue making expensive repairs to your older car because you don’t want to "lose" the repair money you invested in the car last month, three months earlier and six months before that. In today’s market, you might also feel antsy about selling your house for 15 percent less than you bought it, even though you know the sale price is reasonable today.

How to outsmart your brain:

  • Remind yourself that spent money no longer figures into your financial decisions. It’s gone. Would you buy that losing stock today, given its performance, if you didn’t already own it? If not, it’s time to sell. Next time, establish a stop-loss limit (the price at which you will sell a stock) as soon as you buy it, before you get attached to it.
  • Finally, would you put $1,000 into repairing that beater car if a relative had given it to you for free last week? If not, leave the mechanic’s shop — now. You’re trying to financially prop up a sinking ship.

 

Read the full article reference here. (Full credit to Yahoo!)

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