Why You Spend the Way You Do: The Psychology of Money Decisions

Have you ever looked at your financial situation and wondered how you ended up there? Or maybe looked at a specific transaction and asked yourself why you acted the way you did? Then you’re in the right place! The goal of this post is to discuss some tendencies related to financial decisions that can undermine your best intentions. An important aspect of these tendencies is that knowing about them doesn’t make them go away. But being aware of how your brain is working “behind the scenes” can help you steer your financial future in the right direction.

Why your brain takes shortcuts

If you’re reading this, I’m going to make the bold assumption that you’re a human being with real feelings, experiences, and thought processes. As a human being, you make thousands of decisions each day, even if you don’t sit and deliberate over them. Because so many things are grasping for your attention, the brain uses shortcuts to speed up decisions and handle everything being thrown at it. So far, I’ve called these tendencies, but the more accurate term for them is biases. A bias is simply an automatic thought that shapes your opinion without you necessarily knowing it. Here are three biases, how they can subtly influence your financial decisions, and ways to harness their power to help you reach your goals.

Framing bias

One of the most important concepts in how people think about money decisions is framing. Framing is essentially the context around a situation and how that context is used to make or justify decisions. For example, instead of telling my wife that I ate four of the half dozen cookies I bought, I just let her know that I brought her two cookies! When it comes to money decisions, there are a lot of framing examples, but I’ll walk through one here that illustrates the idea and why it matters.

Most people I’ve talked to don’t enjoy the process of buying a car. It’s a big decision with way too many different options and prices, so it’s easy to get overwhelmed or simply not enjoy it. To make things seem a little more manageable, many car buyers end up focusing on the monthly payment rather than the total cost. This is a classic example of framing, and it isn’t exclusive to car dealerships. It also applies to real estate, furniture, and other purchases spread out over months. It’s a fair way for businesses to frame the purchase, since most buyers will be making monthly payments. But as a consumer, it’s important to be aware of how it can add up. Here’s a car loan comparison:

You might look at the column furthest to the right and feel like these are comparable monthly payments, and that a difference of about $20 per month is minor. But looking at the car price and thinking about a full $1,000 leaving your wallet (closer to $1,160 once interest is added over the life of the loan) is a much bigger decision! This example also comes with what I’ll call a “bonus bias” of staying under $600. It plays to left-digit bias, a close relative of anchoring bias, where the first digit of a price carries more weight than the rest, so $599 feels much cheaper than $600. If you want to be as objective as possible with your next car purchase, it helps to think through decisions beforehand with an unbiased guide.

Putting framing to work for you

Try framing each purchase in terms of how long it will take you to earn the money needed. For example, a $100 purchase would take five hours of work for someone making $20 per hour. Another option is to frame saving as paying your future self instead of depriving your present self.

Status quo bias

I’m guessing you didn’t squeeze this blog post into a full day of comparing all of your subscriptions and insurance choices. Status quo bias is arguably the easiest of the biases to understand: change takes more effort than staying the same. Understanding status quo bias might be pretty simple, but it helps to look at how it shows up in your financial decisions.

• Free trials and introductory offers. It’s pretty obvious that companies offering free trials aren’t doing so because they love giving their products away, but it’s a common sales tactic to keep an eye on. Setting a reminder toward the end of the free trial is one way to decide whether you really want to start paying for whatever subscription you likely agreed to when signing up.

• Automatic renewals. Whether it’s your car insurance policy or your Prime subscription, the default option is for the renewal to happen automatically, even if the price goes up. Shopping around for insurance and periodically reviewing other subscriptions are good ways to avoid the pitfalls of status quo bias.

• Unnecessary subscriptions. Personal confession: my car is usually dirty. I’ll go through the car wash when you can barely tell what color it is, but having a spotless car isn’t one of my personal priorities. However, I’m offered a monthly car wash subscription every time I go, and I know myself well enough to suspect I’d never get around to canceling once I signed up. It can be tempting to sign up for various memberships or monthly subscriptions, but it’s often a better deal to just pay for each visit or item individually if you’re not already a regular user.

Making the status quo work for you

Anything that turns your desired financial behavior into the status quo. Routing a portion of each paycheck into a savings account or a retirement savings plan is a great example.

Mental accounting

Mental accounting is something everyone does subconsciously, and it’s simply treating money differently based on where it came from or how you plan to use it. The best example is the well-known tendency to spend tax refunds more loosely than regular paychecks. The same applies to inheritances, gift cards, bonuses, and gambling winnings. I honestly feel like this is the most relatable bias discussed here, since it’s almost entirely normalized through tax refund advertising in the early part of the year.

However, this process ignores one of my favorite financial terms (I think it’s fun to say, and it’s a soft g): fungibility. The idea of fungibility is that all money is the same, so you’re not paying for a vacation with your tax refund; you’re just paying for it with money. Don’t get me wrong, I’m not telling you to boycott vacations or saying that you have to be as boring as possible when you get a bonus. It’s just important to be aware that all of your money is equal, no matter how you got it.

Using mental accounting on purpose

One option is opening a separate savings account for big purchases and treating it as usable for just that purpose, an approach often called a sinking fund. For example, I could open an account at my local bank (avoid fees if you can!) and call it “Danny’s Dream 240-Gallon Aquarium Fund.”

Talking it out

The three biases above can be extremely powerful in how you develop money habits and how you act in certain circumstances. While I just highlighted three big biases here, plenty of others can affect how you spend and save money. One great way to tame your biases and act in alignment with your goals is to discuss money with another person. Whether that’s a Fruition Mentor or a trusted person in your life, having an objective view from someone outside the situation can be extremely useful. I’m off to buy my wife a couple of cookies!