The Behavioral Economics of Everyday Choices: Why We Spend, Save, and Splurge

Have you ever thought about why you bought a product or what drove you to make a financial decision? One of the oldest debates in personal finance is when to save vs. when to buy or splurge. It even ties into the economy's success, whether more people are spending or saving. 

One of the key factors behind these decisions is behavioral psychology. How we think about a financial decision impacts what we do. 

For instance, one of the biggest culprits is impulse buying. Research from Capital One found that the average consumer spends $281.75 monthly on impulse purchases. Studies show that these impulse buys are generally emotional decisions caused by things like perceived satisfaction, the store’s environment, or even stress. 

Therefore, learning the behavioral elements behind these decisions can help when you're trying to manage your financial situation. Let’s dig a bit deeper into the behavioral economics, theories, and principles that contribute. 

Traditional vs. Behavioral Economics

There are a couple of different theories that fall under this discussion. There’s the rational choice theory that ties into traditional economics and the prospect theory that falls under behavioral economics. Here’s a quick overview of both. 

Traditional Economics and Rational Choice Theory

Traditional economics operates on a few primary principles:

1. People are rational. 
2. People will make decisions based on self-interest. 
3. People can change their thoughts and beliefs when introduced to new logical information. 

Rational choice theory ties into that. It explains how people make decisions by weighing the costs and benefits and states that people are most likely to make a decision that provides the most benefit and least harm. 

However, this theory has flaws. The biggest one is it assumes that, in most cases, people will act logically. But, as mentioned earlier, emotional thinking and decisions do play a role. That’s where behavioral economics comes into play. 

Behavioral Economics and Prospect Theory

Behavioral economics combines psychology with economic theories. It’s meant to examine why people make irrational decisions, such as impulse purchases.  

Behavioral economists account for the fact that people can act on emotion, get easily distracted, or be impacted by outside forces. 

For example, you may know that setting aside 10% of your income each month could help you reach your goal of saving for a down payment on a house. However, when your friends invite you out to eat, you see ads for beach vacations, and you want to buy a new pair of trendy shoes, it can feel hard to stick to that goal. 

Tying into that is prospect theory. This theory suggests that people make decisions based on perceived gains or losses rather than absolute logical similarities and differences. Some core principles of prospect theory are:

• Loss aversion: People don’t want to take a loss. They’d rather avoid a loss than take a risk to make an equivalent gain. 
• Reference point: People judge gains and losses based on a reference point, such as their current status quo. 
• Asymmetrical reflection: People judge gains and losses based on how they appear. For example, someone might opt for a smaller cost that’s likely to happen than a larger cost that’s less likely to happen just because they don’t want to face the risk of the larger cost. 

This could apply to the example of the person saving for a down payment on a house. They could feel stressed from work and see an ad for a resort offering an all-inclusive relaxing beach vacation. Based on their current reference point, they may opt for the perceived gain of relaxation from the vacation in the short term and say they’ll start saving for the horse a few months from now. 

Behavioral Economics Concepts in Everyday Decisions

A few other behavioral economics concepts can impact our everyday decisions. Let’s review each to see how it works. 

Hyperbolic Discounting

Hyperbolic discounting is a concept that suggests people tend to opt for smaller immediate rewards over larger delayed rewards. For example, buying a product that’s on sale for 30% off rather than putting that money in your retirement account. It can be easy to justify a small purchase of $19 now. However, continuously doing so adds up over time. 

Bounded Rationality

Bounded rationality states that our ability to make rational decisions is tied to the information we have available right now. For instance, staying loyal to a brand rather than evaluating the other options. You generally know what to expect from the same brand, so it can feel easier to make that decision. 

Mental Accounting

Mental accounting is the tendency to separate your money or payment methods into different “accounts” to determine how you spend. For example, if you pay with physical cash rather than a credit card, it may feel different to see that money has left your wallet. 

The Bigger Picture: Why We Need Behavioral Insights

Understanding the principles of behavioral economics can help you take a step back before making a purchasing decision. Do you really need to spend more to reach the next reward tier in a company’s loyalty program? Or would you be better off setting that money aside and saving it? 

These insights can even help with bigger economic and policy-making decisions. For example, policies like tax deductions for contributing to a 401K plan that encourage people to save for retirement.  

All in all, you can consider these concepts if you want to improve your financial situation. Set goals, and the next time you’re faced with a purchasing decision, take some time to think about it first. It’ll help you put a more well-rounded thought process in place. You’ve got this!