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Ecology of Money

Use Behavioral Finance to Curtail Spending

Eight ways we can reprogram ourselves to side-step our worst consumer impulses.

There's nothing more vexing to those trying to save money than an inability to control spending. It's like trying to drive a car without a speedometer.

The traditional advice in the world of personal finance has been to craft a budget and stick to it. Although that may work for the most disciplined savers, the vast majority of us have more unbridled consumer desires than self-control. Fortunately, the growing field of behavioral economics offers some useful tools to deal with this problem.

Beating overspending is tough for nearly everyone. That's because our brains are hardwired not to resist temptation. It requires significant mental effort to block compulsive behavior, so given a choice between candy and a carrot stick, we often take the sweeter option. Instant gratification gives us immediate feedback and our brains thrive on that.

With the flood of information coming at us constantly from advertising, mobile phones, computers, and other media, we become "cognitively busy," as leading behavioral economics researcher and Nobel Prize winner Daniel Kahneman puts it. Intensive decision-making depletes our already-busy mental faculties, so we take the easy way out. Depleting acts such as deviating from one's diet and overspending on impulsive purchases "all involve conflict and the need to suppress a natural tendency," Kahneman writes in his best-selling Thinking Fast and Slow. Because our brain dislikes conflicts, it frequently takes the smooth, unconscious route to resolution. We buy the coat that's on sale, spend more than we should on that overpriced dinner, and don't save enough for retirement.

So how do we reprogram ourselves to side-step our worst impulses? Here are some insights from recent behavioral research that should help:

1. Use a Default. One of the most pragmatic and brilliant tools to emerge from behavioral economic research is the "Save More Tomorrow (SMT)" program for 401(k) saving. Devised by economists Richard Thaler from the University of Chicago and Schlomo Benartzi of UCLA, this tool automatically defaults employees into a 401(k) contribution and increases contributions over time. The reasoning behind SMT is that those automatically enrolled in a program don't face the conflict of undersaving--or putting away nothing at all. Not making a choice is much simpler than deciding whether to participate, how much to save, etc.

How does this apply to overspending? If you are saving a set amount for your retirement--or in any savings plan for that matter--it's much harder to spend it. This automatically diverts money from consumption into investment and places a certain amount of money off limits--that is, if you don't take an early withdrawal from your 401(k) and don't additionally spend on your credit cards. If you set up an automatic savings plan every month, you won't even have to make a decision about whether or not to spend it.

2. Frame Spending as a Loss. The upside of an impulse purchase (instant gratification) is usually the dominant factor when you're in the moment, but if you can conjure up the downside, that can help you resist temptation. Under Prospect Theory, developed by Kahneman and Amos Tversky, people find taking a loss more painful than a slight gain. What if you reframe a purchase: Characterize an unnecessary short-term purchase as a loss of money rather than an instant pleasure. By reframing the purchase, that creates an unpleasant conflict.

3. Sit on It for a Day or Two. I know this feeling all too well. There's always some electronic gadget I can justify buying, and I'm hot to pull out my credit card. But if it's something that I don't really need, the passage of time diminishes my consumer ardor. 

4. Let Your Spouse/Partner Be Your Guide. According to Meir Statman, who authoredWhat Investors Really Want, research shows that "men across many countries view women as better budgeters. The majority of men in the Philippines reported in a survey that they would be profligate in spending if their wives didn't control their incomes." In many relationships, one spouse is the saver, while the other is a spender. Balance is the key and can work well to stem overspending.

5. Create Disincentives to Spend. Because we're more averse to losses than gains, disincentives can work well to keep cash from going out the door. There are some simple ways of employing "nudges" to curtail spending. Take extra cash and invest it in a certificate of deposit. While the interest on it would be miserably low these days, you're less likely to spend it before maturity because of the early-withdrawal penalty. You could also invest in a 401(k) or individual retirement account, which likewise contain penalties for early withdrawal--income taxes plus a 10% penalty before age 59½.

6. Create Consumption Categories. Thaler suggests categorizing activities as "positive investment goods" (exercise, education) and "negative investment goods" (tobacco, alcohol). That helps us see the long-term benefits of some activities, contrasted with the short-term--and often harmful--effects of others.

7. Use Mental Accounting. Sometimes when we compartmentalize spending, it helps to create spending limits. For a long time, Americans used to set aside "Christmas accounts" for holiday spending. That way, they saved for the end of the year and only spent a finite amount. You can still do the same thing with a separate savings account or pre-paid debit card.

8. Break Out the Total Costs. It's easier to overspend if you don't actually realize how much you're paying. Take mutual funds, for example. Expense ratios tell investors how much the manager is charging them to manage their money. Certainly 1% annually applied to assets under management doesn't sound like a lot. But when you do the math over decades--which can happen when these funds are in a retirement account--it adds up to tens of thousands of dollars. Now that the U.S. Department of Labor requires employers to break out expenses for mutual funds within 401(k) plans, there's no excuse for overspending on management fees. This concept also applies to credit card bills, which are designed to get us to pay only the "minimum" payment and not the entire balance. Banks know that we will rack up much more in finance charges if we stick to the minimum, and it's always a raw deal for the consumer.

The one common element in all of these behavioral bonuses is to take your time and employ the deliberate and cognitive--or as Kahneman describes it, the "slow"--part of your brain. Time may not heal all wounds, but it certainly can prevent you from overspending.

This article originally appeared on Dec. 22, 2012.

John F. Wasik is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.