The Psychology in Spending and Saving
Our decisions about what to do with our money are driven by our psychology.
The rush we feel when spending money is temporary; being more intentional about what we buy can reduce our stress and boost our well-being.
Understanding the psychological barriers against saving money can help us overcome them and make wiser choices.
Like most of our important behaviors, how we deal with money has a psychological component. Here are thoughts on how to use that in your favor.
Spending
We all enjoy the rush of picking, buying, and enjoying what we buy. And often, it’s worth the money. Alas, sometimes we get into the habit of buying as a way to get that jolt, but, like a line of cocaine, it lasts but a short time while the liabilities are long-lasting.
All I want to say about spending here is try to be conscious: Is it in your best interest to buy that? And if you didn’t buy it, how else could you give yourself pleasure: a less expensive version of the item? Or something that doesn’t require spending: for example, speaking with a friend, tackling an easy part of something on your to-do list, taking a walk, playing with the dog . . . or with your romantic partner.
Saving
The classic psychology experiment in which kids were asked to choose one marshmallow now or two later has implications for adults. As a child, I was amazed that if I put $5 into my bank savings account, three months later, not only would it be safe, but it would be worth $5.05 without my having to lift a finger. Atop that is the miracle of compounding: I make money not just on the $5 but the five cents. That sounds trivial, but the benefits are geometric.
Invest $10,000 with a 5 percent rate of return (the historical average return of stock market investments), and in 10 years, it’s worth $16,014; in 20 years, $27.143. I'll have almost tripled my money, and likely stayed ahead of inflation without any effort. If I were to add $1,000 each year, the results would be even more remarkable.
Low-cost, diversified investments such as Vanguard LifeStrategy Funds have had an average return of 7 percent or more since their inception in 1994. Of course, as they say, past performance may not predict future results, but such a track record over its 27-year existence can’t be sneezed at.
There is a psychological tendency that can hurt your return: following the crowd. During a week when the stock or stock market is rising, there’s a tendency to jump in. Thereby, you’re paying a premium for the emotional overreaction.
For example, if the week before, the stock was $10, and this week you paid $11, the company probably isn't much different, but you paid 10 percent more. Conversely, during a week when the stock is declining, there’s a tendency to sell, so you’re paying a premium for that overreaction. To take the previous example, if the stock last week was $10 and amid the market decline, it's now $9, you've received 10 percent less for a share of a company that probably hasn't worsened 10 percent.
There’s no magic formula, but many experts recommend dollar-cost averaging: No matter what the market or stock is doing, buy during the week you have an extra X (say $500) or have that amount automatically purchased from your paycheck. Sell during the week you decide you need the money or based on a decision rule, such as 10 percent down and out: If you’ve picked a stock or mutual fund and it’s declined more than 10 percent, the odds are greater it will continue downward. Warren Buffett said, “Never catch a falling knife.”
During the week, is there a best day to buy or to sell? There's great variation, but it helps to have an inviolate rule to avoid paying the aforementioned overreaction premium. One approach is to capitalize on "The Weekend Effect": buy on Monday and sell on Friday. Why? Because across the decades, on average, stock prices tend to be a bit lower on Monday and a bit higher on Friday.
Another tip to reduce stress: Don’t interpret the wise advice to diversify as meaning you should own many holdings. Not only does that complicate record keeping, but it can also feel overwhelming. Even just one mutual fund or exchange-traded fund (ETF) offers much diversification within a single investment, such as the aforementioned LifeStrategy Funds, which invest in hundreds of stocks and bonds at the remarkably low annual cost of one-tenth of 1 percent.
The temptations to overspend and invest riskily are powerful. Might any of these, for you, be an antidote?
Picture the goal: a decent car, home, college, peace-of-mind retirement, even just the psychological comfort of knowing you have a cushion in case of unexpected expenses.
Investing allows you to make money without the sweat of your labor.
There’s the good feeling of seeing your savings go up. And if you’ve invested prudently, for example, as I described, chances are it will increase. Or you can pretty much guarantee an increase, albeit a modest one, in today's low-interest-rate environment by investing in U.S. Treasury Bills or bank CDs. Almost all of the latter are federally insured.