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December 7, 2009

Longer-term thinking about money

"Investing is simply giving up something now in order to have more of something later." So writes Austin in the Sound Mind Investing Handbook.

It's a simple concept, but one that's difficult to keep in the forefront of our minds because human nature doesn't lend itself to focusing on the long-term. Today and tomorrow seem much more real and important to us than 10 or 20 years from now.

Duke University behavioral economist Dan Ariely, author of Predictably Irrational: The Hidden Forces That Shape Our Decisions, offers a few helpful ideas for longer-term thinking about money in the video below from BigThink.com.

Partial transcript:

[We] went to a Toyota dealership and we asked people, "What will you not be able to do in the future if you bought this Toyota?"
Now, you would expect people to have an answer. But people were kind of shocked by the question. They never thought about it before. So, the most we got was people said, "Well...if I buy this Toyota, I can't buy a Honda."

So, they were making a substitution from the same product in the same time, but in reality, this is not a substitution. They [should be] substituting something in the future. In the future, I will have to give up two weeks of vacation and 70 lattes and 1,700 books. I don't know what exactly the translation is — but when we do consume something now, something else has to give at some point. What is this thing? What is this value of price? Very hard to think about it.

Dr. Ariely also explains how to make better decisions about spending by making the "pain of paying" more apparent.

Imagine you go on a cruise to Alaska and you can either pay six months in advance, or the moment you get off the ship. It's much more reasonable, economically, to pay the moment you get off the ship. But how much would you enjoy the last day of the cruise? It will be kind of miserable knowing that tomorrow you have to pay all of this money.
We [try to] reduce the pain in paying. So, for example, credit cards are wonderful mechanisms to reduce the pain of paying. If you go to a restaurant and you are paying cash, you would feel much worse than if you were paying with credit card. Why? You know the price, there's no surprise, but if you're paying cash, you feel a bit more guilt. It's a bit more difficult. It's more painful to part with your money. With a credit card, eh — it's another time....

Imagine if you had envelopes and your envelopes were telling you how much money you have in each category for the rest of the month. You had an envelope for coffee, you had an envelope for restaurants and you had an envelope for grocery. Now, when you take month out, you also see how much what you have left is shrinking, and that will actually increase the pain of paying more.

Now, I don't think we should go around life and being miserable all the time and feel the pain of paying. It's a question of what categories we want to spend more on and what categories we feel that we are spending too much on and we want to cut down.

It is remarkable that these matters, considered simple common sense just a few generations ago, are now the subject of academic discussion and inquiry. But nonetheless, it is a good thing that "behavioral economists" are helping people understand how to plan their finances and spend responsibly.