There is a 50/30/20 rule of thumb in personal finance, which says one should spend a maximum of 50 percent of his income on necessities, a maximum of 30 percent on discretionary items, and at least 20 percent goes toward savings. But if you are spending 50 percent of your income on discretionary items with little or no savings, then you could fall into the vicious cycle of debt and end up living from paycheck to paycheck.
Now it is easy to spout out advice to anyone in such situations: make a budget, track your expenses, etc.
However, we all know that it is easier said than done. All of us, at some point or other in our lives, have made bad judgments about money. In hindsight, you may attribute those bad decisions to the following triggers:
• Emotional response – The term ‘retail therapy’ alludes to the fact that stress, sadness, anger, jealousy and boredom can sometimes drive us to spend money on anything just to make ourselves feel better.
• Advertising – Using emotional anchors, ads confuse us as to what we want and what we really need. Think Don Draper and Kodak’s carousel ad. People value money less and feel willing to pay more for purchases that remind them of things such as family, pets and childhood memories.
• Instant gratification – I once bought a sewing machine that I did not need. Had it not been for the e-commerce website, I would have never bothered to go to an actual sewing machine shop. Online shopping has made it easier to spend money on things one may not need by providing instant gratification to our impulses.
• No pain of paying – Credit cards with 0 percent APR and deferred payments make us stretch our wallets more than we can afford to because we do not experience the ‘pain of paying.’
In all these examples, you can see emotions at work and our psychological responses working against our saving goals. But knowing this, we can use similar psychological tricks to beat our spending urges and make smarter money decisions. Here are some easy ways to do so:
• Automate – Open a new bank account and transfer 20 percent of your salary as soon as it comes in. Make it harder to withdraw from this account by not getting a debit card for it.
• Delay gratification – When you feel carried away by a deal that seems too good to pass up, defer the buying decision until the next day. Sleep on it and the next day you may not feel the same urge to splurge.
• Focus on absolute savings – You might debate between buying a P50 sandwich vs a P80 one – yet you may not think twice before buying a P1,000 dress rather than P1,050 one, right? The former saves only P30, while the latter saves P50. The fact that sandwich was a 60% saving vs 5% saving on the dress is irrelevant since value of P50 is more than P30.
• Don’t compartmentalize – Do you think the 13th month pay is for holiday spending while the regular salary is for saving? Avoid such compartmental thinking and strive to save a portion of all income regardless of its source.
• Beware of relativity – Mall sales often prod us to be biased by showing pre-sale prices. Restaurants often list higher-priced items first on the menu so other items look relatively cheap. The benchmark in your mind should always be your budget and not relative prices or credit card limits.
To sum up, social, psychological and emotional factors have a significant impact on our daily financial decisions. Known as “behavioral economics,” this fascinating field has a lot of insights that can help us avoid irrational financial decisions. For more advice on this topic, visit our blog here – https://www.moneymax.ph/blog/richard-thaler-nobel-prize-2017
Munmun Nath is managing director at MoneyMax.ph, the Philippines’ leading comparison website for 100 percent unbiased information on insurance, credit cards and loans. For more info, tweet us: @MoneyMaxPH, like us on Facebook:MoneyMax.ph, email your comments to firstname.lastname@example.org, and visit our website: www.MoneyMax.ph