"It's not your salary that makes you rich, it's your spending habits."
-Charles A. Jaffe
I'm sitting at my desk, bored out of my mind. It's 2015 and I work in downtown Minneapolis in a building with a discount store in the basement. It's a Marshalls, but it wouldn't matter if it happened to be a TJ Maxx or Ross. I go down there to kill some time. After a few minutes, I head to the checkout line with an armful of clothes. I don't need any clothes. How can I help it, though? Everything is on sale!
The reason I'm buying so many clothes is the same reason retailers like Kohl's print in large numbers the total amount you saved (the amount you spend is small). I would pick up a shirt, look at the tag, and find out I can get a $99 shirt for $33! What a deal!
I never stop to think about whether this is the best use of my $33. Just because I save $66 (I'm being nice and assuming it wasn't marked up), doesn't mean the shirt is worth $33.
Valuing Our Stuff: How Others Decide For Us
It's really hard to put a value on things. Think about it. How much, in dollars, is a shirt worth? In boring (some would say) economic theory, the shirt would be worth more to someone who needed a shirt than it would be to someone already clothed with a closet full of shirts. But, that doesn't seem to stop people with closets full of shirts from paying top dollar for more clothes.
Since it's difficult for us to figure out what things are worth, we tend to rely on shortcuts. One easy shortcut is to look at the price tag. When we see the price tag we can see how the seller values the product and it's quite easy to decide whether or not we value the item above or below that. When they put it on sale, though, we keep the original price in mind when we consider the value of the item.
It's an interesting idea. We shouldn't care, though, what the old price was. Let that sink in. We spend so much time thinking about how much we are "saving" but the base for that savings is a price at which nobody wanted to buy it. It was a completely inflated price. The new price seems like a good idea because we compare it to the original price. Is it as good a deal if we compared it to other things we could spend our money on? Is giving away my $33 the best use of that money or could it be better used on something else...or saved?
Our tendency to latch onto the original price of an item has a name that behavioral economists and psychologists use; it's called anchoring. Since we tend to be better at valuing comparisons rather than absolute numbers, we try to find a number to "anchor" to. Most of the time the anchor should have little or no impact on our decision, but we use it anyway.
If you think about a physical anchor, it keeps a boat from drifting, effectively keeping it in the same general area. Once you throw the anchor your boat can only drift within a certain range.
That's the same thing with the anchoring effect, except that it usually involves numbers or ideas.
You can think of an anchor price as being an arbitrary number that we latch onto and use when evaluating the purchase. But, we shouldn't be using arbitrary numbers in our logic.
Anchoring Causes "Spend More to Save More"
We've already talked about one anchor, the price tag on merchandise. Another biggie is the MSRP (Manufacturer Suggested Retail Price) of a car. They set the anchor and when you "talk them down" a few thousand dollars, you win because you got a deal. They win because it's still a healthy profit margin. They were the ones who got to set the anchor, though, and we compare the final negotiated price to their anchor, instead of the absolute amount.
Another form is the list price of a house. The listing price shouldn't make a difference when it comes time to value a house, but time and time again research shows that even professional real estate agents fall victim to this.
We can even anchor ourselves to our own behavior. Dan Ariely uses the example in Predictably Irrational that once we buy our first expensive coffee from a coffee shop instead of cheap coffee from a gas station, we have a new anchor set to what coffee should cost. Over time, paying more for coffee becomes easier and easier, because we've anchored to the price of expensive coffee. In other words, we get used to paying the higher price.
When it comes to repaying debt, another anchor that gets thrown is the minimum payment on credit card balances. On one hand, you might be tempted to think that the minimum is there to make sure people pay at least a certain amount; without the minimum people might only pay a few bucks. The alternative viewpoint is that a credit card company wants to make interest and by anchoring your payment amount to a low minimum payment they can nudge you into taking longer to pay off your balance, lining their pockets in the process.
It doesn't even have to happen with straight numbers; it happens with beliefs. If you hold on to a certain belief and new information comes out you still hold on to your anchored belief. You might change your belief, but only slightly because you will still have your anchor attached to the original belief.
A first impression is another example of an anchor. The old saying is that you never get a second chance to make a first impression. This is so powerful because of the power of anchoring. Suppose I was having a really bad day when you first met me. I could have been short-tempered or otherwise seem uninterested. How many times would you have to meet the "real me" in order to convince yourself I'm not the jerk you met? How willing would you be to meet me that many times after that first impression?
The anchors don't even have to make sense. This is how powerful this bias is in our minds. If I asked some of you whether Mark Twain died before or after the age of 103 and then asked you to guess at what age he died, you will likely give higher estimates of his age at death than if I asked you if he died before or after the age of 31.
Take Advantage of Anchoring
You can try to use anchoring to your advantage. If you've put together a simple financial plan (like Carl Richards and Jane Bryant Quinn advocate), you might have a spending plan as part of it. Maybe you have a policy on how you will spend money, perhaps if something is over a certain dollar amount or a certain type of purchase you have to check it with your values. By taking a step back and anchoring your spending to your vision for your life, your plan, and your values, you can use the anchoring effect to help you make sure you are aligning your spending with your values.
Focus on What You Can Control
Remember, you should always focus on what you can control. You can't control what the cost of things are and you can't control whether or not someone threw an anchor out for you to latch onto. You can, however, focus on what's important to you and make sure you are using your dollars to support your good life.
You only have one life. Live intentionally.
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Related Money Health® Reading
References and Influences
Dan Ariely: Predictably Irrational
Dan Ariely, Jeff Kreisler: Dollar and Sense
Daniel Kahneman: Thinking Fast and Slow
Michael Lewis: The Undoing Project
Michael Pompian: Behavioral Finance and Wealth Management
Jane Bryant Quinn: Smart and Simple Financial Strategies for Busy People
Carl Richards: The One-Page Financial Plan
Jason Zweig: Your Money & Your Brain
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