Wealth Perspective

5 Mental Traps Preventing People From Building Wealth

Read this if you're trying to save money and spend less.

5 Mental Traps Preventing People From Building Wealth
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  • "Dollars and Sense," by behavioral economist Dan Ariely and Jeff Kreisler explains that people tend to approach money irrationally.
  • But to build wealth, we have to out-think our emotions.
  • To do it, we have to be aware of psychological pitfalls like "opportunity costs" and the "endowment effect."

Saving money is notoriously harder than it seems. Things pop up -- car repairs, wedding gifts, invitations to concerts -- and suddenly our good intentions go straight out the window. 

So if you're trying to save more and spend less, you'd do well to stop telling yourself how important it is for your future well-being. Instead, you've got to trick yourself.

"Dollars and Sense: How We Misthink Money and How to Spend Smarter" is a new book by Duke University behavioral economist Dan Ariely and lawyer-turned-comedian Jeff Kreisler. The authors outline several ways in which people tend to approach their finances irrationally, and offer a series of creative strategies for becoming better money managers.

Below, Business Insider has rounded up five of the simplest and most compelling insights from the book.

We don't consider where else our money could go

Scientists use the term "opportunity costs" to describe alternatives: If you spend money on one thing, you can't spend it on another. And if you take the time to think about all the things you're necessarily giving up when you spend a sum of money, you might be less inclined to spend it. It's not easy, but it works.

This advice goes back to what Jesse Mecham observes in his forthcoming book "You Need a Budget." If you earmark specific sums of money for specific needs -- say, $100 a month for car trouble -- you'll be less likely to dip into those funds than if you simply designate the money as a general "emergency fund."

We think of money as relative, not absolute

There's a hypothetical story in "Dollars and Sense" that illustrates perfectly how we justify certain expenses. Here's a summary:

You go to buy a pair of $60 sneakers and find out the same pair is on sale for $40 at a store five minutes away. Most people would travel five minutes to save the $20.

Then you go to buy patio furniture for $1,060 and find out the same set is on sale for $1,040 at a store five minutes away. In this case, most people would not travel five minutes to save the $20.

That's because we see every expenditure as relative -- the first is a 33% savings and the second is a 1.9% savings, even though we're saving $20 in both cases.

The authors write: "When relativity comes into play, we can find ourselves making quick decisions about large purchases and slow decisions about small ones, all because we think about the percentage of total spending, not the actual amount."

We mistakenly think our possessions are worth as much to someone else

The "endowment effect" describes our tendency to overvalue the things we own.

The authors use another hypothetical story to explain how the endowment effect can work against us.

 A couple is selling their longtime family home and thinks it's worth $1.3 million. The real estate suggests they list it at $1.1 million, noting that the house needs a lot of work. The sellers and the agent go back and forth about how much the house is really worth.

If the couple had held their ground and refused to list the house at the suggested price, they might never have sold it. Their emotional attachment to their home would have effectively blinded them to the home's objective value.

We value the past over the future

People often fall prey to the "sunk cost effect." As the authors write, "Once we've invested in something, we have a hard time giving up on that investment."

Consider the example the authors provide.

Imagine you're the CEO of a car company and you have a plan for a new car that will cost $100 million. You've already invested $90 million, and suddenly you learn that your competitor is nearly finished with a better car. Most people would spend the final $10 million anyway.

Now imagine the same scenario, except the total cost of development is just $10 million and you've only invested $1. In this case, most people would not spend the rest of the money.

In other words, we let our emotions -- and our hopes and dreams for how the investment was supposed to pan out -- cloud our judgment. But the authors write: "We should think about where we are now and what will happen going forward, not where we came from."

We decide on spending and saving in the moment, instead of in advance

The authors use the term "Ulysses contracts" to describe binding self-control agreements. (The term comes from "The Odyssey," in which Ulysses asked to have himself tied to the mast of the boat so he wouldn't be tempted by the Sirens' call.)

For example, enrolling in a 401(k) means that a set portion of your monthly income is automatically placed into your retirement account. If you've already set up your 401(k) -- well done, you! -- you're acknowledging the limits of your own self-control.

As the authors write, "We only have to overcome temptation once, rather than 12 times a year." And you can use the same strategy for college savings, health-care accounts, and any other kind of savings account.

The authors cite a Harvard Business School study that found women in the Philippines who chose to have money automatically deposited in a savings account increased their savings by a whopping 81% within a year.

This post originally appeared on Business Insider.

Nov 17, 2017
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