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Saving You from Yourself: A Professor’s Tips for Lifelong Financial Fitness

Jan. 17, 2012
Personal Finance
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One of humanity’s major blind spots is our inability to predict our own behavior. Despite evidence to the contrary, we continue to believe that our future selves will be more dedicated, more responsible, richer, smarter, whatever – and that leads to poor decision-making today. The gym memberships bought and used once, the diets that start tomorrow, and the resolutions abandoned two weeks into January (yes, you): all a testament to our fuzzy perceptions of the future.

We spoke with Vassar economics professor Benjamin Ho about financial decisions and human frailty on a personal and policy level. Now that behavioral economics has worked its way into the government – most notably, in the Consumer Financial Protection Bureau – how can policymakers and individuals help to protect us from ourselves?

Hindsight is 20/20, but when it comes to the future…

Among the quirks that keep us from making solid financial decisions, says Ho, is that we have trouble accurately perceiving the future. In numerous experiments, subjects routinely chose a dollar immediately over two dollars tomorrow. This phenomenon, known as hyperbolic discounting, explains why we’ll gladly pay $1,000 in credit card interest for a $100 signup bonus today. According to Ho, a payment in the future seems only half as bad as it does today. That’s why we spend when we should save and get ourselves into debt.

A large part of the problem, says Ho, is that we’re unaware of our own biases and therefore can’t correct for them. Take the visceral dislike many of us have towards annual fees: we’ll turn down a lower-interest card with a fee in favor of a higher-APR, no-fee credit card, even though we end up paying more in interest than we would have in fees. Knowing that this bias exists, however, we could assume that we’ll carry about as much credit card debt as we did last year, calculate our probable interest based on that, and compare the savings on interest payments to the annual fee. Realizing that we’re making an irrational decision is sometimes enough to let our rational selves kick in.

“Well-meaning” policies carry consequences

Policymakers are beginning to craft their regulations with the understanding that humans are sometimes irrational beings. Previously, it was assumed that simply ordering that information be public would guarantee some level of consumer welfare. That was the motivation behind the Schumer box – you know, that thing with rates and fees on credit card applications that nobody reads.

Now, regulators are taking a more nuanced approach. The CFPB is piloting new disclosure forms that help consumers put loan details into terms that they can understand. After the Credit CARD Act of 2009, credit card statements tell you how much you’ll accrue in interest if you make only the minimum payments, and how much you’ll accrue if you pay off your debt in three years. This has the effect of making abstract interest rates concrete.

These developments are “a positive step forward,” says Ho, but he’s skeptical about recent reform. “Economists in general support better, clearer disclosures. Policies that emphasize information and education can help to correct our biases.

“However, legislation makes judgments. It tells companies what fees they can and can’t charge. It may be well-meaning, but restricting one fee will just cause another to appear in its place. We saw this with credit card interest rates,” where legislation capping interest rates caused annual fees to rise, and the legislation’s declawing caused them to fall again.

So if policymakers’ ability to improve our decision-making is largely limited to better information, how should we as individuals correct for our own weaknesses?

The big picture

It’s important to take a holistic view of your finances, Ho advises. For one, debt isn’t necessarily bad if it will produce dividends down the line – student loans are the classic example. Rather than engaging in what Ho calls “narrow bracketing” – viewing each aspect of your finances individually – seek to allocate your money effectively across your entire financial landscape. An example of narrow bracketing would be to dogmatically follow the save-5%-of-your-income heuristic, even though if you took $1,000 out of your savings for house repairs you’d save yourself $5,000 down the line.

Or take saving, for example. It’s generally a good habit to have, but if you’re in debt and you’ve already built up a cushion for emergencies, you’re better off paying down your debt and saving later on. Think of it this way: with the Fed promising to hold interest rates low until the actual apocalypse, not just the Mayan one, you’re lucky to be getting 1% interest on your savings account. Your debt, however, may come with a 10% interest rate. A dollar in your savings account yields you one cent, but paying down your debt saves you ten.

Fight fire with fire

But if you struggle to stick to your financial goals, the structure and rhythm of narrow bracketing may be just what you need. Our cognitive biases can lead us to make suboptimal financial decisions. Ironically, though, making suboptimal financial decisions can help us overcome these biases.

Once again, we’ll look at saving. You’re still in debt and paying 10% interest, and you haven’t magically transported back to the days when you got a 4% yield on your savings. Financially speaking, the best plan for you is to pay off your debt before saving up. But if your problem lies in following your plan, you might have to adjust your strategy.

We are creatures of habit. It can take months or years to establish a pattern, but once the pattern is entrenched, it can become second nature. Rising early to work out five days a week may make for a hellish start to the new year, but come springtime, it becomes as routine as brushing your teeth. The same goes with saving. If you spent the last two years programming yourself to save 5% of your income and you know that breaking that habit will set you back to square one, you might be better off in the long run by continuing to save and taking longer to pay off your debt.

The idea of baiting yourself into making good financial decisions is at the root of Dave Ramsey’s debt snowball. His method has you pay off your debts – after you’ve made the minimum payment on all of them first, of course – in the order of smallest amount of debt to largest. This might have you paying off the last of a 5% APR auto loan before tackling your 15% APR credit card debt. Pure arithmetic states that the best order to pay off your debts is from highest interest rate to lowest, thus minimizing the total amount of interest you accrue. But Ramsey argues that the psychological boost you get from ridding yourself of smaller debts will give you the stamina to tackle the larger ones. Here again, we make small concessions to our weaknesses, so that we may eventually rein them in.

Succeed by planning to fail

The key determinant on which strategy to follow – financially rational or psychologically understanding – is, of course, your own personality. Ho suggests that those who find themselves succumbing to their biases and letting the irrational overrule the rational can benefit from a mind-first approach. Even though your road to getting out of debt or growing your savings might be longer, you can trick yourself into success.

On the other hand, if sticking to a financial plan isn’t a problem, a holistic view of your finances can help you maximize your savings and get rid of debt quickly. Rather than subscribing to axioms, allocate your money between spending, saving and borrowing in a way that’s best for your lifestyle. Debt isn’t always bad and saving isn’t always good. If you can handle the ambiguity, treat your financial plan as a sea chart: it’s a good guide, but you’re best off if you correct your course every so often.