Contributor and Financial Coach
Science is increasingly changing the way we perceive financial responsibility. Recent research has shown that traditional ways of understanding and teaching finance have fallen flat because they don’t take into account important behavioral patterns.
That these traditional modes of teaching finance are underachieving is not hard to see. With millions of Americans in growing debt and unable to cover unexpected bills and costs, it’s time to reevaluate how we understand economics.
One of the most powerful new approaches looks at behavioral and cognitive influences on consumer spending habits. In other words, these concepts look at why we do what we do and then attempt to change that with tailored teaching.
This practice, known as behavioral economics, has become an effective new way to teach finance to others. With successful incorporation of behavioral economics into our lives, we can work to reduce the number of Americans living in debt or underperforming financially.
But what is behavioral economics, and how is it changing the face of finance as we know it? To answer this question, we’ll take a look a closer look at this concept below.
What Is Behavioral Economics?
Behavioral economics expands upon traditional views of finance by looking at why consumers make the decisions they do. Importantly, behavioral economics looks to establish a science behind poor decision making, allowing for individuals to develop better spending habits.
By addressing the underlying thought processes behind bad financial decisions, we can start to reverse poor spending trends.
Generally speaking, behavioral economics is a complex and emerging field that looks to tackle these problems from a number of new angles. These angles can be simplified into six different categories, all of which provide valuable insight into human spending habits.
Below, we take an in-depth look at these six areas of behavioral economics to see how they can reduce the growing American debt crisis.
Factors Behavioral Economics Seeks to Address
As noted, there are six basic problems behavioral economics attempts to target. Each of these distinct factors can help change the current understanding of financial decision-making. With this new knowledge, we can better develop practices to foster positive spending habits.
In essence, these problems currently present major setbacks to the average consumer. By addressing each of these issues, behavioral economics suggests that consumers will be more motivated to make the right decisions in regard to their finances.
Let’s take a look at these six problems below:
Being Mentally Overwhelmed
One of the most common reasons people tend to spend too much is that they get overwhelmed. Because of this, individuals can lose perspective. This causes them to make financial decisions that seem okay at the time but prove to be detrimental in the long run.
If given enough time, we can all probably recall several of these instances in our own lives. Consider, perhaps, that you’ve had a particularly-bad day at work. Things didn’t get any easier when you got home, either, because now you’re tasked with feeding your three young children. And though you’d already made plans for supper, you find yourself taking the easy way out. Instead of spending two hours cooking while being badgered for food, you pick up the phone to order your favorite pizza.
And while it may have seemed worth it in the moment, in reality, you’ve now spent money that you simply didn’t have to. And though these occurrences may be fine if they happen rarely, it’s all too common that such little purchases add up.
It may be, too, that you decide to treat yourself to a new pair of shoes or other form of luxury after making it through a tough week at work. Such impulsive spending leads people to develop bad financial habits—even if they know what they’re doing is wrong.
For this reason, behavioral economics places emphasis on the development of policies and teaching methods that look to combat impulsive spending done when under duress.
Being Too Optimistic About Future Finances
Sometimes the poor decisions made by consumers don’t come from a negative mindset, however. Instead, these decisions are made when consumers overestimate future income or downplay the effects their spending will have.
This can be one of the more difficult problems to realize because many of the people guilty of this aren’t aware of it. However, if you notice that you’re constantly running a little shorter on money than you thought you would be, it’s likely that you’ve been overconfident with your finances.
Behavioral economics looks to change this by allowing individuals to develop more reasonable financial expectations. These methods largely rely on hands-on teaching methods that can train the young or allow older, more experienced individuals recognize their past errors.
Not Understanding the Significance of Rational Decision-Making
Often, impulsive spending can occur when individuals make emotional decisions. It’s worth noting that these situations differ than those experienced by people who are overwhelmed.
On the contrary, these impulses are largely driven by momentary inconveniences that should be easily controllable. Additionally, these impulses rely more on emotion than on rational thinking.
For instance, you may choose to indulge in expensive chocolates when you feel bad or order too much food when you’re hungry. In both of these cases, you’ve been driven to purchase in excess because of an unbalanced emotional state.
Behavioral economics realizes that such purchases can add up for the average consumer—and that for others, they can be much more expensive. By providing teaching methods that allow for impulse control, behavioral economics allows for individuals to make wiser decisions for their future selves. These methods largely work to teach people how to have empathy for their future selves. For instance, you may not buy so much food now if you know that it will limit how much you can eat later in the week. By learning to care for themselves in such a manner, individuals can better stick to proper budgeting practices. In this way, behavioral economics works to improve the financial habits of individuals across a variety of different political and financial systems.
Expecting Instant Gratification
Instant gratification refers to that phenomena where consumers spend impulsively. Individuals who engage in instant gratification make decisions on the moment based on their immediate needs and wants.
Let’s look at an example. Say you are driving down the road when you see a giant letter “M” looming on the horizon. You know you’ve got food at home, but your stomach is growling, and you don’t want to wait the extra fifteen minutes.
What do you do?
You engage in “instant gratification” by going through the McDonald’s drive thru and gorging yourself with hamburgers and fries. You’ve could have gone home and eaten the food there, thus saving money. Instead, you opted to make your life easier in the short term, despite the long term consequences.
Now, you’re out of money that you could have otherwise saved or invested. This is the primary effect of instant gratification. Consumers who engage in this type of behavior frequently find it harder to save money and more difficult to set a true budget with which they can manage their finances.
For this reason, those looking to correct their finances should break the habit of spending on impulse. Doing so could result in massive financial rewards and promote more positive economic behavior.
Developing Harmful Habits
If you have a habit, you already know it’s virtually impossible to break it on a dime. This is true even if your habit is “harmful”—at least in a financial sense.
You can identify harmful habits by evaluating your finances. Say you have thirty pairs of shoes and buy at least one new outfit a week. Most likely, there’s no reason for you to purchase so many clothes—you can’t even wear them all.
In this situation, clothes shopping has likely become so habitual that you don’t even think about it anymore. You see something cute and you buy. This type of behavior is classified as “harmful habits” in behavioral economics and drives a certain part of consumer spending.
Consumers who make purchases based off habit generally spend too much money on one particular habit or field. While we used the example of clothes shopping, it could theoretically be any field in which you have a hobby.
Say you are a bibliophile (or lover of books). You might be able to cut back on your spending if you purchased fewer books and channeled your money into savings. While it may not seem like much, this could eventually be the difference between making that next rent payment or light bill.
Attempting to Meet Social Norms
Behavioral economists have noted that humans tend to follow certain purchasing patterns. In general, these patterns are influenced by social norms. In simpler terms, this means that we do what our neighbors do, and we want what our friends have.
Think about it this way: your daughter’s friend gets the newest smartphone. Then what happens? Of course, she wants it, too. It doesn’t matter that investing in a nice SAT prep book might be more advantageous. She wants what is trendy and socially popular.
In this way, social norms drive much of consumer spending—and not just for teenagers. Say all your friends are buying new cars. You want one, too, but your old car has worked reliably for the last ten years. Still, as more and more of the people around you upgrade their vehicles, you may be persuaded to join them.
In this case, it’s of little importance to you that investing in a good retirement plan may be more useful. As we can see, then, social norms are an important area of study in behavioral economics.
How This Plays Out
Some critics of behavioral economics believe the field lacks true value. In their opinion, the above six criteria can’t be viewed as determinants of consumer spending. Instead, they argue, more pressing matters such as current economic and political conditions have a much greater effect on consumer spending.
While economic upticks and downturns certainly play a huge role in how consumers manage their money, it’s also true that there are a variety of behavioral practices that influence spending. Because these behavioral drivers exist no matter the state of the economy or pending legislation, it’s crucial that we begin incorporating them into any real discussion on money and finances.
This is why: learning what behavioral traits can affect spending will allow people to take control of their finances. When people become aware of their bad spending behaviors and the influencers that drive them, they will be able to correct their spending habits and begin to make better financial decisions.
In the real world, no person makes their spending decisions based on economic situations and policies alone. This view is too simple and does not account for the complex psychological factors that truly motivate human spending.
For this reason, educators should begin to incorporate more behavioral economic lessons into their courses so that individuals can more accurately assess their own behaviors and make any changes where necessary.
What’s more, economics lessons should begin to take into account real-world spending habits that students can more easily relate to. By simulating spending situations based on the six criteria above, educators could begin to provide students with valuable lessons that teach them how to operate financially in real-life contexts.
In addition to this, by starting behavioral economics lessons young, educators would be giving children the tools they need to make proper financial decisions later on in life. With this knowledge nearly second-hand, students would be better equipped to enter the workforce and find affordable housing. They would also be better suited to manage their money and raise families in positive economic conditions.
The Bottom Line
Behavioral economics sheds light on a variety of psychological influencers that can motivate consumer spending. For the average consumer, the field has great utility in helping identify bad spending habits and behaviors that are causing them to lose money.
For this reason, individuals should seriously consider the information in this guide and evaluate how certain behaviors affect their spending choices. In doing so, they could advance their financial situations and be on the path to a brighter economic future.
James Brown | Contributor & Financial Coach
My goal as a financial coach is to empower my clients by aligning intentions with meaningful actions through proactive and tax-efficient planning, to help ensure they reduce economic vulnerability and build enough wealth to live their very best lives, now and in the future.
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