Want to better understand what drives your spending and investing? Listen to Meir Statman, a professor at Santa Clara University, who suggests we are driven by much more than economic benefit. In a recent conversation, we discussed his latest book, Finance for Normal People, and three lessons that may help you comprehend your relationship with money.
Statman is a pioneer of behavioral finance, which combines psychological theory with conventional economics to provide explanations for why people make financial decisions that often seem irrational. For example, spending $10 to present your beloved with a single red rose is a romantic gesture that is likely to be appreciated. But, Statman notes, that purchase has no utilitarian benefits, such as something to eat, drink or wear. Presenting her with a crisp $10 bill to buy what she pleases would certainly maximize her utilitarian benefit. That option, however, fails to factor in what any partner knows: Economic pragmatism is no substitute for a romantic gesture.
Unlike the $10 bill, the rose says to your spouse and others that you are a thoughtful person. Statman calls this an expressive benefit, which is the value of what something communicates to others. And when your spouse shows appreciation, you get the emotional benefit of feeling good. Emotional benefits are the value of how something makes you feel. The fact that the rose is the better gift does not make us irrational; rather, it makes us normal.
What Statman tells us:
1. Understand the tradeoffs between your three wants.
In the rose example, we saw that wants can be utilitarian, expressive or emotional. It is important for people to understand these wants, their benefits and costs, and the tradeoffs between them, Statman says. For example, though a Toyota satisfies utilitarian benefits of getting you from home to work and back, a Lexus adds expressive benefits of high status and emotional benefits of pride. The difference between the price of a Toyota and a Lexus is the cost of the Lexus’ expressive and emotional benefits, and understanding these tradeoffs is important. Some people are willing to pay for the luxury car’s benefits. Others choose the Toyota.
2. Know your financial facts.
Statman cites an example in investing where the data supports owning broadly diversified, low-cost stock funds, which are likely to provide greater returns than hedge funds, heavy trading or hot stock picks. The utilitarian benefit of that data is critical in making investment decisions. A hedge fund may give you emotional status, and heavy trading can offer the excitement of big potential winnings and expressive benefits of being a “player.” Knowing the financial facts helps investors make better choices.
(Roth notes: My investing style maximizes utilitarian benefits of low-cost index funds, increasing profits and allowing me to purchase more expressive and emotional benefits in other areas. I also happen to believe index funds are exciting.)
3. Understand the purpose of money.
The money you save today can be used to meet your needs later in life and is critical in retirement. But while much has been written on getting people to save more, Statman says it’s not so easy for long-time savers to suddenly flip a switch and start spending. He notes many savers overestimate the probability they will run out of money. Say you’re in your 70s and don’t want to spend the money for a vacation cruise. Statman points out that if you put off the cruise until your 80s, your health may not allow you to take it, so take it now. Maybe even take the kids and grandkids. “There is no room for money in your casket,’’ Statman says.
The conclusion is that many financial decisions may not be as irrational as they might seem. Behavioral finance suggests we are not driven solely to maximize wealth, nor should we be. That we aren’t means we are normal rather than irrational. “Understanding our wants, as well as tradeoffs between our wants," Statman says, "leads to using our money to better satisfy those wants, and a happier life, for yourself, your family, and the larger community with which you can share your wealth.”
Allan Roth is the founder of Wealth Logic, an hourly-based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.