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Frank Curmudgeon

This is a guest article by Frank Curmudgeon, author of the Bad Money Advice blog. For updates from Frank, subscribe to the Bad Money Advice RSS feed.

We often see the struggle to get control of our spending as being the conflict between our emotional and logical selves. Emotion wants to go out to that new restaurant tonight, logic says cook at home.

We say to ourselves “If only I could stop and think about all my spending decisions, I’d soon be rich.” That’s not wrong, exactly, but it makes at least one big faulty assumption, that it is easy for us to be logical around money when we want to be. The truth is that just thinking about it is not always enough.

There is an entire field of economics, behavioral economics, which studies the differences between what logic would have people do with their money and what they really do. The academics in this area have collected many such “anomalies.”

Mississippi River

One that illustrates well the illogic of our thinking selves is anchoring, the tendency for people to be influenced by even the most ridiculous estimates of a number. The classic example is that if you ask people if the Mississippi is more than 6000 miles long and then ask them to guess its exact length, they will give much higher guesses than if you had just asked them to estimate its length. (It is 2340 miles long, by the way.)

Dan Ariely, a professor at MIT/Sloan, conducted a striking demonstration of this effect. He asked a group of MBA students to write down the last two digits of their social security number. Then he asked them if they would be willing to pay that amount of dollars for a bottle of fine wine he was holding. Finally he had them submit actual bids for the wine, which he really sold to the winner.

Sure enough, the students tended to bid higher if they had social security numbers that ended in higher digits. So the anchoring effect was there even though the participants were fully aware that the suggested value was completely random, even though they were sophisticated and thoughtful (have I mentioned I got my MBA at Sloan?) and even though it was their own real money at stake. This was not an impulse decision in which consumers let emotion get the better of them. These were would-be shrewd businessmen who undoubtedly assumed that Prof. Ariely was up to something sneaky.

And anchoring explains a few oddities in our everyday lives. It is why houses, cars, and jewelry often have high “asking” or “sticker” prices. The seller does not really expect to get this price and the buyer does not expect to pay it. So why bother? Because by attaching a tag on a watch that reads “$500” the jeweler can more easily talk you into paying $425, even if you know full well that the $500 price was just for show.

And anchoring also helps explain some stock price movements, specifically the phenomenon called price momentum. That is the tendency for stocks that have been going up over the past few months to continue to do so.

Imagine that there is an exciting growth company that announces some positive news when its stock trades at $50. There is a large group of investors who love this company, are excited by the news, and would, in principle, pay $100 a share. However, because of anchoring, they just cannot bring themselves to pay more than $10 above what the stock was trading at in the past month. It just seems expensive. When the stock goes above that level these buyers back off, temporarily. After a few weeks, the current price does not seem so unreasonable, because they get used to it, and they resume buying. The result is that even though in a more logical environment the stock would have gone to $100 immediately, what actually happens is that it climbs steadily at about $10 per month over five months.

It’s important to understand that anchoring doesn’t happen because you are stupid, or too emotional, or overly influenced by advertising. It happens because you are human. It is the way your brain is wired up. You can’t stop yourself from doing it, although being aware of it is a great help.

The point is that merely resolving to think about how you spend is not enough. Spending logically is harder than it looks.

Photo credit: Don3rdSE