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Editor’s Note: Last month, behavioral economist Dan Ariely and his team at the Center for Advanced Hindsight opened up the Common Cents Lab. Its goal is twofold: to examine how those living in poverty misspend their money and to help the poor make better financial decisions. I spoke with Ariely about the center, our not-so-rational spending and why making good financial decisions becomes even more difficult when you’re poor. For more on the topic, read the second half of Making Sen$e’s interview with Ariely here. The following conversation has been edited and condensed for clarity and length.
— Kristen Doerer, Making Sen$e Editor
Kristen Doerer: How does being poor affect people’s financial decisions? What factors affect their decision making?
Dan Ariely: Well, none of us always make the best financial decisions. One of the big lessons from behavioral economics is that we make decisions as a function of the environment that we’re in. And what is the environment that you’re in, in terms of your money? They — as in everyone — want to take it away from you. Your immediate environment is comprised of coffee shops, supermarkets, websites, apps and all kinds of things — none of which have an interest in your long-term or short-term financial well-being.
So you can think about life as a battle between you and a doughnut shop. The doughnut shop wants you to eat another doughnut and pay the money, and you want to do it in the short term, but in the long term it’s not good for you either financially or from a health perspective. And so people need help, and it’s not just the poor.
Kristen Doerer: What kind of help?
Dan Ariely: Well, think about something like a 401(k). 401(k) savings are in some sense irrational, because why would you take money out of your paycheck at the beginning of the month when you don’t know how much money you’ll need? What you should do is wait until the end of each month, and then say, “OK, how much money do I have? How much do I need? Let me send the rest to retirement.”
But we all know if that was the case, we would never save. So what do we do? We implement something that takes money automatically from our checking account without us having to think about it. And at least this way we save. But if you think about it as a tool, it relies on you to make one decision one time when you join your employer, and that’s about it.
Not everything can be as automated as this, and for people who don’t have a regular salary, this is complex. The idea that you will make the right decision every time is very unlikely. So what we need to do is give you tools to help you make better decisions at the moment or to commit to something that would make it impossible to deviate from the status. So we think that it’s all about tools that help you remember in real time that you don’t really need this gadget, or that if you buy this lunch, it comes in at the expense of something else.
Kristen Doerer: So that kind of reminder in real time really helps people save money and not spend it.
Dan Ariely: Well, money is all about opportunity cost, right? Every time you spend on something, that’s something you can’t spend on something else. And the problem with opportunity cost is that opportunity cost is divided among many, many things. If you went ahead and bought a new watch today for $50, what is it coming from? What would you not be able to use the money on? It’s very unclear, because it would come from a lot of different things. And so not only is opportunity cost is hard to think about, but technologies make it harder to think about.
So if you had $50 every day, the opportunity cost would be clear. If you buy an expensive lunch, you would not have money for dinner. Or if you buy dinner, you won’t have money for medications. But if I gave you the money monthly and added to it credit card bills and student loans and car payments and the mortgage and the retirement fund, now all of a sudden, it’s not that clear what you’re giving up. OK, so that’s for all of us. For all of us, it’s very hard to think about money, and because of that, we need help. In the same way that for all of us, it is hard to eat well, and we need some help. The poor have a particular challenge, which is that their life is actually much more complex — and they’re much more complex cognitively.
Kristen Doerer: What do you mean, they’re more complex cognitively?
Dan Ariely: There is this tremendous research on what is called “depletion.” Depletion is the idea that as we make difficult decisions, we just get tired of making difficult decisions, and as we get tired, we are much more likely to succumb to temptation.
So imagine temptation: You’re tempted to eat a muffin in the morning, then you’re tempted to send your boss a nasty email during the day, and then there is Facebook while you’re at the office, etc. But now imagine that you’re poor, and you have a decision in the morning about whether to take the bus or to have breakfast, and you have a decision to make in the day on whether to buy medications or put money aside for rent. Those decisions are incredibly depleting. It’s just an exhausting way to live. And because of that, the poor who have many more of these difficult decisions actually live a much harder life.
It’s very sad, right? The people who need to overcome temptation to the highest degree have the hardest time doing it.
So if you live in a poor neighborhood, for example, what are the odds that there is a bank branch that is open by the time that you get off work and get the bus home? Very low. And if you do have a grocery store, what is the chance that they carry fresh fruits and vegetables or yogurt?
So what happens is that the poor is kind of starving for money, of course, but also for time and for cognitive capacity. And I don’t want to say that the poor are inherently cognitively diminished, but at the end of the day of making difficult, tough decisions, it’s very hard to have the energy to think about things with the right mindset. Imagine that you’re a parent, and you get home, and your kids say they want a pet or they want McDonald’s or something, how easy is it to resist this temptation after a day of depletion?
Kristen Doerer: Is there a difference between long-term and short-term decision making when you’re poor, because you’re thinking about, say, paying rent this month versus saving for the future?
Dan Ariely: Again, it’s the mindset. So I can give you an example. I was in the hospital for many years with a lot of pain. When people are in severe pain, there’s an expression, you’re a “pain person,” and what that means is that nothing else matters. When you’re in pain, tomorrow doesn’t exist — just the pain — and the only thing that you want in the world is for it to go away. That’s a very hard state to be in and think long-term thoughts. So if you’re hungry, when you need medications for tonight, how likely are you to going to think long term?
Here’s another question: Have you ever rented a vacation home?
Kristen Doerer: Yes.
Dan Ariely: Do you remember going to the grocery store for the first time and trying to equip the kitchen of the vacation home? So you start from scratch and you buy olive oil, and you buy salt, and you buy pepper, and the cost is just tremendous. And now if you have $500, you can invest in all the things that will make the cost of the meal reasonable later. But if you don’t have the starting $500, it’s really hard.
So we actually visited some poor homes, and there are people in the U.S. that the only cooking facility they have is the microwave. Think about getting into an empty apartment and let’s say you live on a budget of $20 or $30 a day. On what day are you going to buy a hot plate? On what day are you going to get salt, pepper, olive oil, utensils, pots and pans? It’s an investment that will pay off over a while, but it’s really hard to get into that mindset.
Kristen Doerer: So what are examples of bad financial decisions people make when they are dealing with depletion?
Dan Ariely: So a very simple bad decision is to get into debt. And that is very expensive. Not all debt is bad. From time to time we should get into debt when there’s a good reason for that.
But the problem is that people basically dangle debt in front of us. And the cost for the poor of course is much higher than for the wealthy. How do you resist temptation when it’s so easy to get? So how can we get people to think very differently about debt and to think about the true cost of debt and what they are giving up?
And by the way, the companies that provide debt, what do you think their goal is? Is their goal for you to fully understand the cost of your debt? No. So they’re basically creating these approaches to make you feel like it is incredibly cheap or just to think about the cost per day rather the cost per year or cost for a lifetime. So debt is very simple mistake.
We did a study looking at what debt people pay first. So imagine you owe on five credit cards, you owe five debts. So which debt should you pay first? And the answer is very simple: You should pay the one with the highest interest rate first. But that’s not what people do. What people do is they pay the small loans first. Why? Because they enjoy making the number of loans smaller. But of course it is a very ineffective way to pay debt down.
Another thing people don’t do is that they don’t have specific savings accounts for specific purposes. By the way, this is just shocking. We did another study on trying to get people to take their tax refund and save some of it. So at tax time, we said, “OK, you’re getting this refund, maybe you should save some of it.” It was shocking to realize how many low-income Americans don’t have savings accounts.
Kristen Doerer: Really? No savings accounts?
Dan Ariely: But think about it, when you get a checking account, you should have a savings account, and the number for the savings account should be one off of your checking account. Right? It just seems so simple, and we should do things that move money from one one to another. But in most places you open a checking account completely separate and people don’t have savings accounts.
So how do those people save? It’s kind of shocking, but they basically prepay their rent for three months. So they took the money and made it a liquid by putting it to a different goal. If you think about it, it is a form of saving, but it’s not the ideal form of saving. Their logic is: “I don’t have a savings account, I don’t want the money to sit in my pocket, because I don’t want to spend it on other things, so I’ll prepay my rent.”
Kristen Doerer: You mentioned before that many low-income Americans don’t have specific savings accounts for specific purposes. I don’t think I have ever had a specific savings accounts for a specific purpose. Can you expand on that?
Dan Ariely: So there is an amazing study that shows when parents have college savings accounts for their kids, their kids show higher social and cognitive performance. And the reason is that the parents get a statement once a month that says this kid has a college savings account, and their parents think about them differently and treat them differently. This was a randomized control study — it was just opened for them randomly.
Think about how you would think about yourself if you had no assets versus how would you think about yourself if you have a college savings account for your kid? Or if you had an account called “my first apartment,” and you’re in your 20s. How would you think about your future, or how would you think about putting money there?
Kristen Doerer: So are you self-signaling to yourself that you are the type of person who will have their first apartment or that you will go to college?
Dan Ariely: It’s not only signaling, which is a crucial part of this, but the specific savings account also tells you something about the next step. So if you don’t have that account, and you just have a checking account, how exactly will you save? It’s very hard. But if you have an account with names and time frames, it really, really helps.
Dan Ariely is the James B. Duke Professor of Psychology and Behavioral Economics at Duke University's Fuqua School of Business. Ariely studies how people actually act in the marketplace, as opposed to how they should or would if they were rational beings. Dan’s bestselling books about behavioral economics include "Predictably Irrational," "The Upside of Irrationality" and most recently, "Irrationally Yours."
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