Dollars and Sense is one of my favorite books because it combines two of my favorite topics: Money and Psychology. It reveals how we think about money and the mistakes we make when we do. After all, money is a difficult concept.
But we’re not helpless. As long as we’re willing to dig deeper into human psychology, we might improve our behavior, our lives, and our freedom from financial confusion and stress.
Most of us think about money a lot of the time: how much we have, how much we need, how to get more, how to keep what we have, and how much our neighbors, friends, and colleagues make, spend, and save. Luxuries, bills, opportunities, freedom, stress: Money touches every part of modern life, from family budgets to national politics, from shopping lists to saving accounts.
Money represents VALUE. Money itself has no value. It only represents the value of other things that we can get with it. It’s a messenger of worth. Money makes it easy to value goods and services, which makes it easy to exchange them.
Money is a common good, which means it can be used by anyone for (almost) anything.
But just because we can do almost anything with money, that doesn’t mean we can do everything. We must make choices. We must make sacrifices; we must choose things not to do. That means, we absolutely must, consciously or not, consider opportunity costs every time we use money.
The way we should think about the opportunity cost of money is that when we spend money on one thing, it’s money that we cannot spend on something else, neither right now nor anytime later.
Opportunity costs are what we should think about as we make financial decisions. We should consider the alternatives we are giving up by choosing to spend money now. But we don’t think about opportunity costs enough, or even at all. That’s our biggest money mistake and the reason we make many other mistakes. It is the shaky foundation upon which our financial houses are built.
In an ideal world, we’d accurately assess the value of every purchase. “What is this worth to me? What am I willing to give up for it? What is the opportunity cost here? That is what I will pay for it.” But, as fitness magazines remind us, we don’t live in an ideal world: We don’t have six-pack abs and we don’t accurately assess value.
We often cannot measure the value of goods and services on their own. In a vacuum, how could we figure the cost of a house or a sandwich, medical care or an Albanian three-toed blork? The difficulty of figuring out how to value things correctly makes us seek alternative ways to measure value. That’s where relativity comes in.
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.
Relativity is built on two sets of decision shortcuts. First, when we can’t access absolute value, we use comparisons. Second, we tend to choose the easy comparison.
Happiness too often seems to be less a reflection of our actual happiness and more a reflection of the ways in which we compare ourselves to others.
A single dollar bill obviously has the same value as any other dollar bill. In theory, that’s true. In practice, however, we don’t usually assign the same value of every one of our dollars. The way we view each dollar depends on which category we first linked this dollar to—or, in other words, how we account for it. This tendency to place different dollars in different categories is certainly not a rational way to deal with money. But, given how difficult it is to figure out opportunity costs and real value, this strategy helps us budget. It helps us make quicker decisions about the ways in which we spend our money.
It shouldn’t matter how we label the money since, in reality, it’s all ours. But we do assign money to mental categories, and this categorization controls how we think about it from that point on. How comfortable we feel about spending it, on what, and how much we have left at the end of the month.
How we spend money depends upon how we feel about money. Yes—another hidden factor that influences how we compartmentalize our money is how it makes us feel. Do we feel bad when we get it because it arrived under negative circumstances? Do we feel it is free money because we got it as a gift? Or do we feel good, like we worked hard for the money so we deserve it?
We play with malleable mental accounting when we allow ourselves to classify expenses ambiguously and when we creatively assign expenses to different mental accounts. In a way, that helps us trick the account owner (ourselves). If our mental accounting weren’t malleable, we’d be strictly bound by rules of income and expenses. But since it is malleable, we manipulate our mental accounts to justify our spending, allowing us the luxury of overspending and feeling good about it.
The most common way we cheat on our mental accounting comes from the way we think and misthink about time. Specifically, the time gap between payment for an item and our consumption of it.
The end of an experience is very important. Think of closing prayers at religious services, dessert at the end of a meal, or goodbye songs at the end of summer camp. Ending on a high note is important because the end of an experience informs and shapes how we reflect back on, remember, and value the entire experience.
The pain of paying is what we feel when we think about giving up our money. The pain doesn’t come from the spending itself but from our thoughts about spending. The more we think about it, the more painful it is. And if we happen to consume something while thinking about the payment, the pain of paying deeply colors the entire experience, making it far less enjoyable.
The pain of paying should get us to stop making painful spending decisions. But instead of ending the pain, we—with the “help” of financial “services” like credit cards—devise ways to lessen the pain. Using credit cards, e-wallets, and automatic bill-pay is the equivalent of putting on little “financial helmets.” Like bad doctors, we treat the symptom (the pain) but not the underlying disease (the paying).
When consumption and payment coincide, enjoyment is largely diminished. When they are separated, we don’t pay as much attention to the payment. We sort of forget about it, and as a consequence, we can enjoy our purchases much more.
The pain of ongoing, simultaneous payment isn’t necessarily bad. It just makes us more acutely aware of our spending.
Free is a strange price, and yes, it is a price. When something is free, we tend not to apply a cost-benefit analysis to it. That is, we choose something free over something that’s not, and that may not always be the best choice.
Anchoring occurs when we are drawn to a conclusion by something that should not have any relevance to our decision. It is when we let irrelevant information pollute the decision-making process.
Self-herding is the same fundamental idea as herding, except that we base our decisions not on those of other people, but on similar decisions we ourselves have made in the past. We assume something has a high value because we valued it highly before. We value something at what it “normally” or has “always” cost because we trust ourselves with our own behaviors.
Confirmation bias pops its head up when we interpret new information in a way that confirms our own preconceptions and expectations. Confirmation bias is also at work when we make new decisions in ways that confirm our previous decisions.
The less we know about something, the more we depend on anchors. Anchoring has a weaker effect when we have some rough idea of value versus when we have no idea. When we start with an established value and price range in our minds, it’s harder for outsiders to use anchors to influence our valuations.
Arbitrary coherence is that, while the amount that participants were willing to pay for any item was largely influenced by the random anchor, once they came up with a price for a product category, that price became the anchor for other items in the same product category.
Investing in anything causes us to increase our sense of ownership, and ownership causes us to value things in ways that have little to do with actual value. Ownership of an item, no matter how that ownership came to be, makes us overvalue it. It’s called the Endowment Effect.
Effort gives us the feeling of ownership, the feeling that we’ve created something. After we invest effort in almost anything, we feel extra love toward that thing we had a part in creating. It doesn’t have to be a large part, and it doesn’t even have to be a real part, but if we believe we had something to do with the creation, we increase our love and, with that, our willingness to pay. The more work we put into something—a house, a car, a quilt, an open floor plan, a book about money—the more attached to it we become. The more we feel we own it.
Successful advertising copywriters are, in a way, magicians: They make us feel like we already own their clients’ products. It’s not real ownership; it’s virtual ownership. The fantasies inspired by commercials get us to connect to their product. That connection creates a feeling of ownership, which leads to a higher willingness to pay for those products.
The endowment effect is deeply connected to Loss Aversion. The principle of loss aversion holds that we value gains and losses differently. We feel the pain of losses more strongly than we do the same magnitude of pleasure. And it’s not just a small difference—it’s about twice as much.
Sunk cost is finding that once we’ve invested in something, we have a hard time giving up on that investment. Thus we are likely to continue investing in the same thing. In other words, we don’t want to lose that investment, so often we throw good money after bad, adding a dash of wishful thinking.
When evaluating a transaction, traditional economic models simply compare the value to the price. Real, human people, however, compare value to price plus other elements, like fairness. People can actually resent the efficient, perfect economic solution when it feels unfair. That feeling affects us even when a transaction makes sense, even when we would still get a great value.
Assessing the level of effort that went into anything is a common shortcut we use to assess the fairness of the price we’re asked to pay.
It’s easy to pay for conspicuous effort. It’s harder to pay for someone who is really good at what they are doing—someone who performs the job effortlessly, because their expertise allows them to be efficient. It’s hard to pay more for the speedy but highly skilled person, simply because there’s less effort being shown, less effort being observed, less effort being valued.
Fundamentally, when we value effort over outcome, we’re paying for incompetence. Although it is actually irrational, we feel more rational, and more comfortable, paying for incompetence.
We are willing to pay more when we see the costs of production, people running around, the effort involved. We implicitly assume that something labor-intensive is worth more than something that isn’t. It is not objective effort so much as the appearance of effort that drives the psychology of what we are willing to pay.
But businesses don’t often do this. Yes, transparency helps us understand value, but, sadly, if we’re running a business, we typically don’t expect that explaining the effort behind our product or service will change the way customers evaluate it. But it does.
Language can make us pay extra attention to what we consume and direct our attention to specific parts of the experience. It can help us appreciate our experiences more than we might otherwise. And when we get greater pleasure from something—whether from the physical experience of consuming it or from the language describing it—we value it more and we’re willing to pay more for it.
Consumption vocabulary gets people to think, focus, and pay attention, to slow down and appreciate an experience in a different way and then experience the world in a different way.
One other path by which description creates a powerful influence on how we value things is in conveying effort and fairness. As we just saw, such terms of effort are extremely important. Terms like “artisanal,” “handcrafted,” “fair trade,” and “organic” are used to not only signify creativity, uniqueness, political views, and health, but also signal extra effort.
Language can not only create a perception of effort and a sense of value; it can also get us to attribute expertise to the people using these terms.
This use of language creates what author John Lanchester calls “priesthoods”—using elaborate ritual and language that is designed to bamboozle, mystify, and intimidate, leaving us with a feeling that we are not sure what’s being talked about but that as long as we use the service of these qualified people we will be in expert hands.
Enjoyment comes from the experience we are having from the external product or service and from the experience of consumption, which, by expanding our sense of connection to past experiences and creating a sense of meaning, increases our enjoyment.
The rituals we undertake during consumption make the experience special. We own it more; it becomes a greater investment, one that is more entangled in our own lives and experiences. We also get a greater sense of control through rituals. An activity becomes familiar. It becomes our own when we ritualize it. We are in command. That adds value, too.
Our own valuations are affected by the expectations of our most trusted analyst: ourselves. If we expect something to be really, really fantastic, we will value it more highly than if we expect it to stink.
The moment we begin expecting something, our minds and bodies begin preparing for that reality. That preparation can, and typically does, affect the reality of the experience.
Expectations have been shown to improve performance, enhance the consumption experience, and change our perceptions, thereby affecting our ability to assess value and willingness to pay. Like language and rituals, expectations help us focus on the positive—or negative—aspects of that experience, thus giving those elements lots of weight. From wherever they may come, expectations have the power to change our reality.
Delayed gratification and self-control are not strictly about the psychology of money, of course, but our ability to delay gratification and to control ourselves influence how we manage (or really, how we mismanage) our money, for better or worse.
We tend to value certain things right now in the present much more highly than we value them in the future. Something that’s great for us—but won’t arrive for days, weeks, and months, or years—isn’t as valuable to us as something that’s only okay for us but is available right now. The future simply doesn’t tempt us as much as the present does.
The difference between our choice about now and our choice about the future is simply that decisions made in the present involve emotion, whereas decisions made about the future do not.
When we imagine our reality in the future—our lives, our choices, our environment—we think about things differently than we do in the present. Today our reality is clearly defined, with details, emotions, and so on. In the future, it is not.
Poor saving is really just one manifestation of poor willpower. But saving requires more than just willpower. To save we must first calculate a saving strategy, then we must acknowledge the emotions tempting us to veer away from that strategy, and then we must exhibit the willpower to overcome those temptations that await us behind every corner.
As phones, apps, TVs, websites, retail stores, and whatever the next commercial frontier is get better, they also get better at tempting us. The good news: We’re not helpless. We can overcome some of these problems by learning about our behavior, about the challenges we face, and about how our financial environment encourages us to make poor choices. And we can use technology to help us overcome—to help us think about using money to serve our own long-term interests, rather than serving others.
Another important way we value things—a way unrelated to actual value—is by assignment meaning to a price. When we can’t evaluate something directly, as is often the case, we associate price with value.
Whether it makes sense or not, a high price signals a high value. In the case of important things like health care, food, and clothing, it also signals that the product isn’t cheap or of low quality. Sometimes the absence of poor quality is as important.
Prices shouldn’t affect value, performance, or pleasure—but they do. We are trained to make quick decisions based on money with every single transaction, and, especially in the absence of other value markers, that’s what we do.
We love precision—and the illusion of precision—because it gives us the feeling that we know what we are doing. Especially when we don’t.
The strange thing about money is that, even though we don’t understand what it is, it’s measurable. Whenever we encourage a product or experience with many different properties, along with one precise and comparable attribute (money), we tend to overemphasize that specific attribute because it’s easier to do so. It’s hard to measure and compare features like flavor, style, or desirability. So we end up focusing on price as a way to make our decision, because we can measure and compare it more easily.
More often than not, though, the feature we overemphasize when we make our decisions is the one thing that is always easy to see and evaluate: price.
So, if we tend to focus on whatever is most measurable and comparable, is there something wrong with that? Well, yes. It can be a big problem when the measurable thing is not the most important part of the decision.
Money works the same way. It isn’t the final goal in life, it’s a means to an end. But because money is much more tangible than happiness, well-being, and purpose, we tend to focus our decision-making on money instead of on our ultimate, more meaningful goals.
When we move from comparing money to things to comparing things to things directly, it puts our choices into a new perspective.
We think of our future self as a somewhat separate person, so saving for the future can feel like giving money away to a stranger rather than giving it to ourselves. One antidote is to reconnect to our future selves.
Use simple tools to help us imagine our future self more vividly, specifically, and relatable. It can be as simple as having an imaginary conversation with an older “us.” Or we can write a letter to an elderly version of ourselves. We can also simply think about what our specific needs, desires, greatest joys, and toughest regrets will be when we’re sixty-five, seventy, ninety-five, one hundred.
Talking with our future selves is one useful step toward shifting our thinking and building more willpower to resist the temptation of now.
One study found that people discounted the future less when it was described with a specific calendar date rather than as an amount of time. We are more likely to save for a retirement that happens on “October 18, 2037” than for one that happens “in twenty years.” That simple change makes the future more vivid, concrete, real, and relatable.
The struggle to improve our financial decision-making isn’t just a struggle against our personal flaws; it’s also against systems designed to exacerbate those flaws and take advantage of our shortcomings.
What we do know is that the future will make our spending decisions even more challenging. From Bitcoin to Apple Pay, retinal scanners, Amazon preferences, and drone delivery, more and more modern systems are designed to make us spend more, more easily, and more often. We are in an environment that is ever more hostile to making thoughtful, well-reasoned, rational decisions. And because of these modern tools, it’s only going to get more difficult for us to make choices that serve our long-term best interests.
We can amplify our knowledge by designing systems, environment, and technologies that help us rather than tempt us. We can employ the very same behaviors and technologies that cause us harm to do us good. We can turn it all upside down on its head. We can use our quirks to our advantage.
Experts at Fidelity Investments recently learned that the investors whose portfolios performed the best were those who had completely forgotten that they had investment portfolios at all. That is, the investors who simply left their investments alone—without trying to trade or manage, without getting trapped by tendencies to herd, overemphasize price, be loss averse, overvalue what they own, and fall victim to expectations—did the best.
We need that type of road sign to interrupt us on our financial journeys, to wake us up from our financial sleepwalking. And we need that sign to appear pretty often, just to provide a moment, a pause, some additional friction, something to take us off automatic, keep us present, and help us consider what we’re doing.
Money is a difficult and abstract concept. It is hard to deal with and hard to think about. But that doesn’t mean we’re helpless. So long as we understand incentives and tools and our own psychology, we can fight back. If we’re willing to dig deeper into human psychology, we might improve our behavior, our lives, and our freedom from financial confusion and stress.