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https://retirementplans.vanguard.com/VGApp/pe/pubnews/AmericansBroke.jsf?SelectedSegment=ThinkingaboutRetirement

Why so many Americans are broke
Bookstores are full of books about getting out of debt. Why, then, are so many Americans struggling to get by?

One reason, according to Connecticut College Psychology Professor Stuart Vyse, is that when it comes to money, people are not as rational as many economists—and authors—think.

In his book Going Broke: Why Americans Can’t Hold on to Their Money, Vyse cites studies that consistently show that people commonly make mental mistakes when it comes to their money.

This realization is the foundation of behavioral economics, which holds that people behave differently than in the supremely logical fashion that classical economics predicts.

Money mistake 1: Big spenders on credit
Students at MIT were offered a chance to buy Celtics tickets at auction. Half were told they must pay in cash; the other half could pay with a credit card.

When all the bids were submitted, the credit card bidders were willing to pay more than twice as much, on average, for Celtics tickets than cash purchasers.

The true value of a basketball ticket is what people are willing to pay for it. But the study suggests that when we pay with plastic, we tend to overspend.

"The loss of cash is an immediate and very concrete event," Vyse concludes, "but placing an additional debt on a credit card is a more delayed and diminished form of loss," which makes it easier to accept.

Money mistake 2: Splurge with a windfall
A group of Harvard students were each given $50. Half were told the money was a "tuition rebate." The other half were told it was "bonus income."

A week later the students were asked what they did with the money. Those who were told the money was a "tuition rebate" had spent $7 of the $50, on average. But those who were told it was "bonus income" had spent $31, on average.

The experiment showed it was easier to spend a "bonus," which was perceived as a windfall, than a "rebate," which was perceived as a return of some money you’d paid.

It doesn’t matter where the $50 actually came from. Yet people seem to part with windfalls more easily than dollars they’ve worked for because they account for the money differently in their minds.

"We often place money from different sources into different mental compartments, some of which are more accessible than others," Vyse writes. "Some mental accounts encourage spending—even when it's not a good idea—and others discourage it."

Money mistake 3: Not driving a hard bargain
A Stanford University psychology professor posed this hypothetical question: Imagine you're in a department store buying a calculator for $15 and a jacket for $125. The salesman tips you that the calculator is on sale for $10 at another branch of the store, located 20 minutes way. Would you drive there to save $5?

When his research was published in 1981, 68% of respondents said "yes," they'd drive to the other store to save $5 on a calculator. But if they were told that the $125 jacket was on sale for $120 at the other store, only 29% said they would bother to make the trip.

In both cases the trip would save the consumer $5. But the $5 savings felt small in relation to the price of the jacket, and large in comparison to the price of the calculator.

Yet $5 is $5 however it is saved.

Money mistake No. 4: Paying more for decor
A group of Cornell students is asked to imagine they have spent the day at a hot beach. Their companion calls on a cell phone and offers to bring them their favorite beer from a fancy resort hotel nearby, but warns that it might be pricey. How much would they be willing to pay?

When this study was conducted in 1985, the students, on average, said they would pay $2.65 for a beer.

Then the students were told a slightly different story. This time the source of the beer was a run-down grocery store. The average price these students were willing to pay fell to $1.50.

The beer was the same whether purchased from a posh hotel or a grungy store. But students were willing to pay more when the seller conveyed an atmosphere of luxury.

Even Ivy leaguers flunk these tests
According to classical economics, human beings are logical when it comes to money. If given sufficient information, they will make the most of their dollars.

But these four experiments—administered on students at some of the finest universities in the world—reveal that smart people make mistakes when it comes to handling money.

What can be done? Vyse offers several practical suggestions to check our tendency to part too easily with our money:

First, set up automatic contributions to a savings account. It's hard to save because it requires willpower. That's why Vyse suggests making the saving automatic. So even if you do nothing, money is set aside for the emergencies, such as unexpected car bills.

"There is no to need dirty your hands with the task of making savings deposits, nor do you have to strain your brain trying to remember to save each month," Vyse writes, if you set an automatic savings account.

Second, build in delays to buying. You may want a new high-definition TV, but make it a rule not to order any nonessential item for at least a day or two.

"Building in a delay is one way to help you distinguish between a real want—an enduring desire that has some true meaning—versus an ill-considered act of fancy," Vyse writes.

Third, use windfalls wisely. When unexpected money lands in your lap, don’t let it blow back out of your life just as randomly.

Pay off debt with a windfall rather than buying something new, Vyse suggests. If you have no debt, contribute any windfalls to savings.

If you have no debt and plenty of savings already, Vyse advises, "do whatever you want with windfalls."

Fourth, pay by cash or check. If your credit card bills have you over a barrel, Vyse advises carrying cash and your checkbook.

Credit cards facilitate spending, Vyse notes, and parting with cash is harder. So paying with cash may help to reduce your spending—and it can’t add to an outstanding credit card balance.

Chocolates in the house
"Some might think the financial tragedies they see around them is a sign of diminished character that current generations have forgotten the lessons of the Great Depression and are simply less prudent than their parents," Vyse writes.

But he doesn't think that having trouble handling money is a moral failing. "There is ample evidence that the demands on our self-control are much greater than they once were," he contends.

Technological advances in banking and marketing have introduced 24-hour shopping by phone, television, and the Internet. Merchandisers have entered our homes, making it possible to spend money anytime of the day or night.

"It takes greater effort to hold on to your money than it did a generation ago," Vyse writes. "People vary in their self-discipline and their ability to control the urge to spend, but it is also much easier to avoid eating chocolates when there are none in the house."

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PeakTrader said...
The article doesn't prove people are irrational or make "mistakes."

Mistake 1: Did the "wealthier" consumers really overspend? Did they get the tickets (unlike the poorer consumers)?

Mistake 2: Is a $20,000 wedding equal to a $20,000 auto purchase? Why do people tend to go overbudget for a wedding, but not for an auto purchase? The difference does matter.

Mistake 3: Consumers are more uncertain about a higher priced good than a lower priced good. So, when a cheaper good falls by $5 and an expensive good falls by $5, the consumer is more likely to buy the cheaper good.

Mistake 4: It's rational to assume beer is more expensive at a "fancy resort hotel" than "a run-down grocery store."

If you want to test if consumers are irrational or make mistakes, then you tell 100 people there are 100 tickets and you can each bid for one ticket. It's likely every bid will be not more than immaterial to each bidder.

Anonymous said...
If you don't like the frequency of purchase of high vs low priced items argument, then try this risk- based argument :

Assume that every item you purchase has a 5% probability of either being defective or just disappointing you when you get it home, as you suffer buyer's remorse.

When you spend $10 for a $15 calculator, you save $5 but you have an expected loss of 5% of $10, or - $0.50 for a net gain of $4.50.

When you buy the $125 jacket for $120 you gain $5 but have an expected loss of 5% of $120 or - $6
,for a net loss of -$1.

In an uncertain world, buying high priced items results in a higher level of risk to your achievable standard of living.

Regards, Don

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PeakTrader said...
Some people need to ask is a relative increase in living standards at the expense of an absolute increase better than an absolute increase in living standards at the expense of a relative increase.

PeakTrader said...
Jet, I doubt economists at the Bureau of Labor Statistics are being paid-off or are politically motivated. A minimum 3.5 GPA is required for economists at the BLS. They're serious technocrats and they'd know if there was systematic bias, which would defeat the purpose of their work. Of course, measuring the largest and most dynamic economy isn't an easy task.

Jet Beagle said...
Peak trader: "I doubt economists at the Bureau of Labor Statistics are being paid-off or are politically motivated. ... They're serious technocrats and they'd know if there was systematic bias, which would defeat the purpose of their work."

I agree completely. I have great respect for their work and for the complexity of their task. I just wanted to find out what niknaknoo used as the basis for his implied criticism.

PeakTrader said...
Average Household Size by Asian Ethnic Group in Massachusetts:

A few groups:

Chinese 2.86
Japanese 2.07
Filipino 2.76
Pakistani 3.36
Vietnamese 3.91
Cambodian 4.73
Korean 2.40

morganovich said...
peak -

GDP price inflator is not a real number.

it's a calculation based on a whole set of assumptions and estimations.

i really think you over-estimate its usefulness.

Walt G. said...
Shouldn't an adjustment be made for the increase in two-income households vs. one-income households from 1967 to 2007?

I believe as the number of children in the household was decreasing, the number of income earners was increasing. I don't see how we can compare 1967 to 2007 without accounting for that factor.

Anonymous said...
I don't have a link to the stats handy, but my previous investigations have shown that there hasn't been much of a change in number of workers per household over the last 30 years.

No doubt a lot of Two Parent/One Worker households have been replaced by One Parent/One Worker households.

Walt G. said...
anonymous 6:01,

You might be right. A shift to one parent households could negate the shift to two-income households over time.

A valid analysis would have to study the same people over time from low income (and low wealth) to high income in their working years and back to low income in their retirement years (and high wealth).

PeakTrader said...
Walt G, the U.S. Census Historical Income Tables-People Table P-13 Marital Status--All Races 18 Years Old and Over by Median Income and Sex: 1974 to 2007 show Median Real Income of Male Workers has been flat since 1974, between $30,000 and $35,000, while Median Real Income of Female Workers increased from $12,500 in 1974 to $21,500 in 2007.

Morganovich is correct about the implication that some data don't reflect reality. Comparing the quantity and quality of assets and goods per person in the 1970s to today shows Americans didn't have much in the 1970s.

http://www.census.gov/hhes/www/income/histinc/p13AR.html

Walt G. said...
PeakTrader,

I think what is needed is a longitudinal study of the same random sample of people over time. I'm not an expert on this, but I believe those data are hard to come by.

Male income flat while female income rising over time? Isn't that expected with females entering the workforce, increasing the labor supply, and decreasing the labor demand?

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Real Median Household Income

http://3.bp.blogspot.com/_otfwl2zc6Qc/S03clEXrZ3I/AAAAAAAAMco/D0Fk-xXrabY/s1600-h/income1.jpg

http://3.bp.blogspot.com/_otfwl2zc6Qc/S03ck4FIjfI/AAAAAAAAMcg/EFwp_Dss9wE/s1600-h/income2.jpg