Staying on track with your finances all the time can be difficult. Sometimes you just want to order dessert on a night out or to go to that concert with your friends, even if those things are outside your budget. It can feel overwhelming to plan for the long term, but the good news is that these emotions are totally normal — in fact, they’re based in science!
Behavioral economics looks at how psychology motivates money habits, often in a way that can be detrimental. While financial responsibility is typically very cut and dry, human behavior is rarely so linear, and this can lead to decisions that are financially counterproductive. The upside is that evaluating the behaviors that cause poor financial decisions can lead to better money habits in the future.
What is Behavioral Economics?
Behavioral economics studies the psychological, emotional, cognitive, cultural, and social factors that influence our decisions. In the realm of finance, behavior scientists put science behind your spending — and saving — habits. The idea is that addressing the underlying behaviors and thought processes that drive a person’s decisions can also provide a framework for understanding the tendency to make bad or irrational financial choices.
Traditional economic theory lives within the realm of rationality, but behavioral economics teaches that a person’s natural, emotion-driven tendencies regularly don’t line up with the systematic nature of finance. This means that we are often driven, both on an individual and an institutional level, to make money decisions that satisfy us in the moment rather than being optimal for the long-term — so your choice to buy that expensive cup of coffee even if it puts you over budget has a basis in psychology. By better understanding your own underlying thought processes, you can practice better financial decision making like changing your saving habits.
Overcoming Bad Habits
A major step to understanding how to use behavioral economics to build better money habits is first knowing your money personality, which is influenced by everything from your personal values to the advertisements you see regularly. For example, are you a Money Avoidance type, often ignoring your finances, or a Money Status personality, equating your net worth to self-worth? Once you’re familiar with how to define your own relationship with money, you can maximize your money personality to better suit your financial needs and goals.
One of the more common reasons that people tend to spend too much is decision paralysis. When you feel overwhelmed with too many options, it can be easy to make no decision at all. This can hold you back from making important financial choices that save you money. Tunneling happens when you pay attention only to the emergency or need at hand rather than focusing on your long-term goals. Another common behavioral pitfall is planning fallacy. This is when you underestimate how long it will take to complete a task, such as paying off your credit card balance.
One way to overcome these behaviors is by using goal gradient theory, breaking down your major goals into smaller, more manageable objectives. For example, when building an emergency fund, try setting monthly goals in addition to your annual goals and your overall target amount. If you’re trying to save $9,000 to your emergency fund over three years, then your annual goal is $3,000 a year or $250 per month.
Another way to reset your financial behaviors is through mental accounting. Mental accounting is a behavioral economics concept that refers to the different values people place on money and how they organize funds. Oftentimes, people will value a dollar the same regardless of where it came from (for example, a dollar earned at work has the same value in a person’s mind as a dollar gifted to them), as well as its intended use. Mental accounting can be used to your advantage if you make the decision to treat money differently depending on both its source and destination. A quick way to organize your mindset is to name your savings accounts to align with the different places you plan to allocate your funds. Try having an account for budgeting and a separate account for discretionary spending.
Once you’re aware of how your natural decision-making tendencies affect your spending, it becomes easier to improve upon your habits. The best piece of advice is to start small! You might not be able to correct all your financial routines right away, but you can choose to focus on at least one behavior to work on each week. Slowly you’ll start to see improvements in both your finances and your own relationship with money. And if you need some extra help, try reaching out to a financial counselor. Our partners at GreenPath provide judgement-free financial counseling at no charge to HUECU members. Humans are built to make mistakes; in the world of finance that can seem pretty scary, but knowing where you tend to misstep can help you start moving in the right direction.