Your Instinctive Thinking Is Losing You Money

Imagine for a moment that you are in the market for a new suit. You find one that you like for $200. A fellow customer then tells you that the same exact suit is on sale across town for only $100. Do you go?

Imagine that you are buying a new car. You’ve done your test drives and made a final decision on which make and model you want. You go to the dealer near your home to find that the car costs $30,000. A salesman sees you eyeing the car and says, “My manager would kill me for saying this, but the dealer on the other side of town has this model for $29,900.” Do you go?

If you’re like most people, you drive across town in the first example, but not in the second. You’ve decided that in the first example it is worth the extra time to drive across town to have an extra hundred dollars in your wallet, but in the second example it isn’t worth the same amount of time to save the same amount of money.

If you took that position, then you’re not alone.

 

The Studies

A Kahneman and Tversky paper cited a study that explored this issue.

They asked people to imagine one of two scenarios.

They told the first group to imagine that they were purchasing a jacket for $125 and a calculator for $15. The salesman points out that if they drive to another branch 20 minutes away, they could get the calculator for $10 instead.

They told the second group to imagine that they were purchasing a jacket for $15 and a calculator for $125. The salesman points out that if they drive to another branch 20 minutes away, they could get the calculator for $120 instead.

In both scenarios, the 20 minute drive would result in a savings of $5 on a $140 purchase. And yet, 68% said that they would make the drive when the calculator was $15, but only 29% would make the drive to save on the $125 calculator.

An economist named Ofer Azar took this idea and ran with it. He used a number of different items and different price points and asked what the minimal price difference would need to be for someone to make a 20 minute trip to a cheaper store.

When people were buying a $3 pen, they said that they would drive across town for a savings of $1.88. They needed to save $11.37 to justify the same trip for a $100 jacket. On a $3,000 computer, they wouldn’t travel for anything less than $62.89 in savings. And for a $30,000 car they needed to save $454.81. Anything less than that was not worth an extra 20 minutes.

 

The Analysis

This makes a sort of intuitive sense. If I can save over 60% off the price of this pen, I should jump on that deal! And why would I bother driving across town just to save 1% off the price of my car?

But if you take a moment to think about it, it quickly becomes clear that this doesn’t actually make any rational sense at all.

A dollar is a dollar is a dollar. It doesn’t matter whether that dollar is still in your wallet because you saved 50% on a $2 item or 1% on a $100 item. That dollar still buys you the exact same soda from the vending machine.

If you’re willing to spend 20 minutes of time to save $11.37 on your $100 jacket, then you’ve decided that your time at that moment is worth about $34 per hour. Why is it that when you are buying a car, the value of your time all of a sudden jumps to $1364.43 per hour?

Clearly there is a problem here. We instinctively think in relative values rather than absolute. This makes sense in most areas of our lives.

The Upshot noted that “what we experience as consumers is like what we experience when we listen to music or lift a heavy object. For example, we are more likely to notice that a drumbeat is loud if we have been listening to, say, a gentle violin. And we will notice that we are lifting extra pounds if they are added to a lightly packed suitcase. The same additional weight is barely noticeable in a heavy one. Vision, heat perception, smell and taste all obey a similar law: Perception is largely a relative mechanism.”

This instinct to think in relative values may serve us well in some domains, but it hurts us when dealing with money.

 

The Solution

So what’s the solution? Nobody likes the guy who points out a problem and then doesn’t help you solve it.

I think I’m that guy today, though.

The best that I can recommend is to be aware of this tendency and to work to combat it as best you can. Take the extra few moments to work past your instinctive reactions and try to think about the numbers in rational and absolute terms. Build the habit of ignoring percentages in favor of raw numbers. It isn’t natural or particularly easy, but it will save you a lot of money.

 

Got any other suggestions? Please let us know in the comments! I’d also be interested in hearing your stories on whether you have noticed this issue or encountered it before. Or, feel free to brag if you are one of the few who is able to easily and naturally avoid this trap that the rest of us fall into.

14 thoughts on “Your Instinctive Thinking Is Losing You Money”

  1. I think the key to the dilemma was the one you mentioned in your article…thinking about your hourly rate of return. Because, yes, i got all excited yesterday when Mr Groovy told me I can get eggs at Aldi for 49 cents a dozen, which is over $1 less than I usually pay. But it takes an extra 20 minutes to go to Aldi, and I’m spending at least an extra $1 in gas to get there. Is it worth the trip? Only if I can factor in savings on more items than just a dozen eggs.

    But it’s a great thing to think about for Christmas shopping. Gosh knows I’ve been tempted to make some extra trips around for bargains only to realize that after factoring in gas costs and the threat of picking up impulse buys, I come out better to spend just a little more to order them online.
    Emily @ JohnJaneDoe recently posted…State of the Blog: November 2016My Profile

  2. I love these kinds of studies. I don’t have them at my fingertips anymore, but we did a lot of similar exercises in b-school talking about time value of money. Except instead of taking a 20 minute drive, they would ask, “Would you rather have $100 today, or $115 two years from today?” Even highly educated people are very bad at internalizing the ideas of inflation and interest, especially compounding.

  3. We did a couple of these exercises when I was getting my MBA and I always found it interesting hearing the conversation during class around the rationality. Hearing people talk in relativity instead of absolute was always something that struck me as interesting.

    I have to admit my mind always goes to relativity and I really have to think hard about absolute value. it definitely does not come naturally to me even when I know better.

    Thanks for another great topic!!!
    Mustard Seed Money recently posted…What To Do With A Bonus?My Profile

  4. Interesting post! I didn’t realize our instincts were tuned more toward percent than absolute. I’ve definitely noticed it work that way before in my mind and I need to ask myself if that really makes sense. I remember one of my favorite professors always saying that dollars paid the bills, not percents and that’s always stuck with me.

    Thanks for the great post, Matt!
    The Green Swan recently posted…The Swan Life: November 2016My Profile

  5. I love it, Matt. You’re making me think today. Focus on absolute savings rather than relative savings. What a great money mantra. Too bad it doesn’t come easily to the human brain. I got to work on this. I know my default behavior to to judge relative savings. I wouldn’t go across town to save $100 on a car. But I would for a suit. Damn this personal finance stuff is hard.
    Mr. Groovy recently posted…Prepare for Impact: You’re 55-Years-Old and BrokeMy Profile

  6. I think the only issue is that focusing on absolute is risky too since 130 dollars today is not 130 20 years ago or 20 years from now in terms of purchasing power. While we do view savings relative to what were spending we also view total dollars in relation to what we’ve used it for before or forward. So in some ways you have both a moving perception and a moving absolute value combined.

    1. That’s a fair point. I suppose then that we need to focus on absolute numbers in the short term and relative over the long term. If you’re trying to get the best deal on something now, then you want to be thinking in absolute terms. If you are considering how much you need to save to retire ten years from now, then you want to add some relative thinking in.

      Thanks for the comment!
      Matt recently posted…Your Instinctive Thinking Is Losing You MoneyMy Profile

  7. I always love these studies. Thanks for pointing it out! I’ll have to pay more attention to this from now on 🙂

    I think the correct way to think about this like you mentioned is just the opportunity cost of your time. I usually think this way when I’m trying to save time even though I have to pay up a little bit–like paying for parking downtown versus driving around for street parking
    Andrew recently posted…3 Great Investing Books You Need To ReadMy Profile

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