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Thursday, 15 May 2008

In a Tough Economy, Self-Understanding Is Key

by Laura Rowley

With a sluggish economy and prices for food, gas, and other necessities escalating, many consumers are taking proactive steps to shore up their finances, according to a recent survey of 2,000 adults by Yahoo! Finance and research firm Decipher.

Getting Proactive

In the past six months, 68 percent held off on a major purchase; 60 percent have begun proactively paying down debt; and 41 percent have proactively increased their savings.

Some 90 percent of people surveyed believe the United States is already in or headed for a recession, and 8 in 10 say they expect the recession to last more than a year. In addition, 20 percent report that someone in their family has lost a job within the past six months.

Since fear tends to beget irrational economic behaviors, here are some suggestions to maximize decision-making for people reorganizing their household budgets.

Understand the Dynamics of Self-Control

In response to current economic conditions, some 56 percent of survey respondents say they'll "only buy the essentials, as opposed to what they want." But a resolve to go cold turkey on all but the necessities will likely break down (and lead to whipping out credit cards to seize a must-have temptation).

Roy Baumeister, a social psychologist at Florida State University who studies self-control, suggests that human beings have a limited capacity for resisting temptation. Acts of discipline have a cumulative effect: each instance of self-restraint weakens us a little more. His experiments have found self-regulation was weakest among people who had already performed a prior act of self-control.

Moreover, Baumeister has found that willpower tends to dissolve when we have to make multiple decisions. Uncertain or conflicting goals also undermine the basis for self-control. That's why a vague vow to "spend only on necessities" is doomed to fail.

Instead, target just one or two specific and measurable goals, such as keeping grocery spending to $100 a week; reducing utility bills by $50 a month; or increasing earnings by $100 a month. Nearly two-thirds of respondents in the Yahoo! Finance poll say they're making clear-cut changes to reduce their spending, including carpooling, brown-bagging lunches, and reducing clothing expenditures.

Know What Your Time Is Worth

When you're cutting your budget, make sure the cutbacks actually leave you better off financially. This is easier said than done. For example, I made a somewhat irrational decision and eliminated the weekly service that cuts my lawn and blows away the pollen and leaves. My lawn is pretty small, I reasoned, and we could do it ourselves if we purchased a leaf blower.

There were numerous downsides to this decision: I got a leaf blower for Mother's Day. The only lawnmower we own is a push job from the 1950s that our neighbor gave us when we moved in. It took my daughter and me about an hour to cut the grass, during which I was sneezing my head off because of pollen allergies and nearly cut off one of my toes. (Now I know why the lawn guys don't wear flip-flops.)

Most important, since my spouse and I are both self-employed, we have the opportunity to increase our income if we work another hour. Thus it actually makes more sense for me to stick with my computer and have this job done professionally, since our time is worth more than the cost of the service. My solution for the moment is to assign the yard chores to my kids (wearing sneakers and protective goggles), which means it'll cost half as much, help develop their work ethic, and keep the dough in the family.

Manage Your Emotions

Researchers have found that it's just as important to manage your emotions around spending as it is to manage your behavior. Gregory Berns, an Emory University neuroscientist, has found that the brain is wired for novelty, surging with the chemicals dopamine and cortisol when we encounter something new. Would-be budgeters have to consciously move their thoughts and emotions away from spending traps -- reducing exposure to television, ad-laden magazines, and catalogs in the mailbox.

And, obviously, avoid the shopping mall like the plague. Carnegie Mellon economist George Loewenstein has studied what he calls the "hot/cold empathy gap," which leads to errors in predicting feelings and behavior.

When people are in a "cold" or neutral emotional state, they often have trouble imagining how they would feel or what they would do if they were in a "hot" state -- angry, hungry, in pain, or surrounded by "50 percent off!" signs. When we're experiencing a hot state, we have difficulty imagining that we'll cool off at some point. One study found that people who aren't in a shopping situation underestimate the "urge to splurge" that takes over when they enter a mall.

Get a Handle on Mental Accounting

Half of households report maintaining a budget, according to a Yahoo! Finance survey conducted last year. But even those who don't budget usually keep separate accounts in their heads that they typically group into current income, current assets, and future income.

Economists and psychologists call this "mental accounting." It can be helpful -- it keeps us from withdrawing money from a 401(k) retirement plan to pay for groceries -- but it can also lead to irrational behavior. Credit cards tend to obliterate good mental accounting; see my blog for that story.

In one classic experiment by Nobel laureate Daniel Kahneman and the late Amos Tversky of Stanford, participants were asked to imagine that they'd paid $10 for a ticket to see a play, and lost the ticket. Would they go to the ticket booth and buy another? Some 54 percent of respondents said no. Then participants were asked to imagine they decided to see a play that cost $10, but as they enter the theater discover that they lost a $10 bill. Would they still pay $10 to see the play? Some 88 percent of people said yes -- although in both instances, the economic impact is exactly the same.

Going Mental

How can you make mental accounting work for you? Create a separate category for bonuses and windfalls. For instance, don't treat your tax rebate as regular income and use it to pay monthly bills (which 38 percent of Yahoo! Finance survey respondents plan to do). Instead, direct special windfalls toward savings or debt pay-down. (That's what 43 percent and 32 percent of survey respondents, respectively, say they'll do.)

When you make a decision from a single mental account, recognize that the money is fungible, as economists like to say -- or interchangeable. In other words, we should appreciate the fact that the lost theater ticket is equivalent to the lost $10 bill. Compare large expenditures to other purchases that might offer more utility -- that $3,000 couch could be a $3,000 vacation, for instance.

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