And Now For the Reality of an "America First" Economy

http://www.msn.com/en-us/money/markets/economic-growth-expectations-are-quietly-falling-through-the-floor/ar-AAo28Zj?ocid=spartanntp

Saving Doesn’t Mean What You Think It Does

Learn the savings-related errors you’re making and how to correct them.

Jacqueline Verrilli

_________________

Saving money is a hot topic these days, whether related to how to pay for health insurance in a fast-changing marketplace or how to ensure a comfortable retirement on a moderate income.

But do you understand what “savings” really means, and how to best go about it?

More than likely, your concept of "saving" is inaccurate, influenced by cognitive errors based on misinformation and media messaging. These errors lead to dangerous misconceptions and logical gaps related to your decision making about saving money.

The good news is that such errors can be identified and corrected, resulting in a better understanding of savings—and more money genuinely saved.

Words Matter

Many of us gain some satisfaction from finding grocery or other items on sale, or using coupons and rebates to reduce their cost. We’re saving money, we tell ourselves.

That’s not the case.

Shopping, by definition, involves spending, not saving. Spending less is still not saving.

An informal online survey I conducted revealed that over two-thirds of respondents believe “taking advantage of sales, coupons, and discounts” is a good way to save money. Even when the disconnect was pointed out to them, the majority of respondents felt that the common usage of the word “saving” made it “fair” for them to conflate spending less with saving (even as you’re reading this, it’s likely hard to dissociate those terms).

Part of the problem is a cognitive error called an “availability bias”: the use of some form of the word “save” in advertising is ubiquitous, making it easy for us to erroneously think of spending less on discounted goods and services as truly saving; the easy availability of that association makes us believe it.
 

But the idea that purchasing anything could be considered saving money is, by economic principles, preposterous. And it gets worse, as we’ll discuss next.

The Discount/Overspending Paradox

It doesn’t hurt to spend less money on items you would have bought at a higher price otherwise. But spending less only translates into savings if the amount you didn’t spend is placed into a financial savings vehicle such as a bank CD or retirement account. What actually happens, though, is the money you don’t spend on, say, a box of cereal or a new TV remains in an account accessible for discretionary spending and is typically spent on more of that item or some other item, often in the same store! 

Research from the University of Pennsylvania shows that people who go into a store armed with a mental budget have “slack” built into that budget, enabling them to make additional purchases at their discretion. So, if they find a planned purchase is discounted, they often buy more of it, thus spending more than intended on that trip, with the rationale that they will spend less on that item longer term. On its face, such “stockpiling” is rational behavior that reduces the effective cost per unit of an item. But it can ultimately be harmful when consumers amass too much of a given item and waste it due to changing tastes or spoilage. It’s fair to guess that too many of us have untouched discount-club store purchases collecting dust in our basements.

The second problem is more insidious: shoppers often purchase unplanned items while in a store, whether because they believe they’ve “saved” money through discounts/stockpiling or merely because they see desirable items, discounted or not. Research from Notre Dame University shows that making even one unplanned purchase opens the door to additional ones.

These behavioral patterns mean that taking advantage of discounts in any form may actually result in spending more, or what I have dubbed the “Discount/Overspending Paradox.”

The Bother of Budgets

Dissociating the concept of saving from spending less is a big step toward better savings-related decision-making.

But let’s pull even further back to think about budgets.

According to Gallup, no more than a third of Americans uses any kind of household budget. That’s a major problem as there’s no way to save money systematically, or to save “more” money—as most of us would like to—without an understanding of, and goals related to, how much we spend on  expenses. We do recognize this connection: many of my survey respondents listed budgeting as an important savings-related tool.

So the first step is being willing to budget. If you don’t use an online financial-management program such as Mint.com already, consider signing up, or check out these free budget templates. A household budget helps you determine your fixed expenses (such as mortgage, car payments, food staples, and insurance), understand your historical discretionary expenses (dining out, clothes, entertainment), and identify savings opportunities. Of course, any amount “saved” isn’t truly considered savings until you’ve placed it into a savings vehicle, as I hope I've made clear above.

Unfortunately, there’s often a large mental gap between having a budget and actually following it faithfully. One issue is that your official budget may be in annual or monthly terms, but you need to make spending decisions on a weekly or even daily basis. For example, in financial terms, the “pro rata” amount you could spend for the week on groceries would be your annual budget divided by 52 weeks; so if you budgeted, say, $7,800/year for groceries, that would equate to $150/week. But your mental budget upon reaching a store may be very different, depending more on how flush you happen to feel at the time (did you just receive a paycheck or bonus?), your mood, or other factors. And, of course, you have the Discount/Overspending Paradox discussed earlier to contend with, as well, which can be more pronounced for middle and upper-income shoppers.

In short, you have to be willing to keep a budget in the first place, then do your best to align your official budget with your mental one by figuring in smaller time increments (weekly or daily instead of annually), and identifying factors that may throw you off. Any additional money not spent, then, can be placed in a savings or investment instrument.

Lifestyle 2.0

The more we earn, the more we spend—and thus the less we save, proportionately.

My survey respondents, mostly from middle and upper-middle income levels, almost unanimously agreed they needed to improve their saving habits. But the reality is that as our incomes rise, we tend to purchase larger homes and more luxurious cars, meals, goods, and vacations.

To save, many of us target spending less on discretionary items—maybe we will go out to eat less often or to less expensive restaurants, or stream a movie instead of going to the theater. This may make a difference if you’re consistent, but there’s a potentially much more powerful approach: reducing your fixed expenses.

Fixed expenses are generally larger and easier to identify than smaller, more frequent, discretionary expenditures. A typical household’s most common fixed expenses are in housing (including real estate taxes), insurance (health, auto, home), and transportation, which together compose a substantial portion of the budget. So just cut down on one or more of these, right?

The problem is that almost no one is willing to downgrade on lifestyle. Psychologists call the taste for increased luxury “hedonic adaptation”—once we’ve been to a ritzy hotel we tend to prefer such accommodations. The research of renowned cognitive scientists Daniel Kahneman and Amos Tversky shows that once people have something (or even anticipate having something), it becomes a “set point,” or a new baseline expectation, such that anything less is considered a loss. Similarly, they found that we tend to feel losses more strongly than gains, helping to explain why so few of us are willing to downsize our houses—or most anything else—to save money.

Let’s use housing costs as part of a fuller example of savings-related trade-offs. If, like most people, you purchase a home using a mortgage, then the larger the mortgage the greater the total payment —including interest. Less costly homes also tend to have lower insurance rates, lower real estate taxes, and lower maintenance costs. But if these were the only considerations, most of us should opt for a smaller home. In reality, owning a home is not just an expense but an investment that pays returns beyond financial: location, comfort, space, community, and others. That means the “utility”, that is, the total economic enjoyment, of owning a particular home may outweigh some post-retirement perks like frequent tropical vacations.

Moreover, since society still values home-ownership highly, there’s a strong availability bias, such that few consider renting a permanent solution for housing. Making the same lifestyle choices as others is known as "herding" and it can take a great deal of self-reflection to overcome.

You can see how analysis of choices/trade-offs for even one major budget line item can get complicated quickly. But thinking things through can produce important information to guide your savings decisions.

Death and Savings

Many of my survey respondents take advantage of direct deposit and other automated money-transfer tools to build long-term savings vehicles.

While that’s a good habit, the problem is that people who “pay themselves first” in this way tend to feel that the amount they’re saving, whatever it may be, is sufficient for the post-work lifestyle they desire. Many retirement savings calculators suggest otherwise: living on just 15% to 30% of your current income, even with decades of compounded interest, is not feasible for all but the most frugal among us.

To really determine how much you need to save for the future lifestyle you want, you’d have to reasonably estimate the entirety of your future earnings, create rational approximations of your post-retirement living expenses, account for inflation, investment income, and compounding, and then base your current spending on the present-day budgets you’ve made using those forecasts. It’s safe to say that the vast majority of people haven’t completed that exercise, including economists and financial planners!

Part of the challenge is uncertainty. We know that people are generally living longer than before, but it’s hard to say how long any particular person will live, complicating long-term financial planning. But using the average age of death and adjusting for your family history and health habits should get you in the ballpark.

Still, few of us like to think about our mortality. Economists “get” that it’s an evolutionary advantage to fear death. But to save strategically, you need to overcome that fear. That means you should have a spreadsheet or some other budgeting tool that extends through your best-guess life expectancy, with scenarios for exceeding that target. And you should revisit this document at least annually to adjust for any unexpected events, such as a substantial period of unemployment (pro tip: everyone should plan for at least two years of unemployment in their lifetime, and for decreased income after age 60).

Define “Saving” for Yourself

To be clear, I’m not advocating that you need to downsize your home or give up ownership to rent. I’m not asking you to reject coupons, sales, and discounts. The point here is to carefully consider the now, the future, your preferences, and how you came to have those preferences, because most people are not making rational choices by economists’ standards.

In even simpler terms, you might later discover that you would like to have pursued saving differently, had you thought more about the bigger picture and the choices you made within it.

Remember: strategies to achieve your savings goals will likely not come from the first ideas that come to mind. Availability biases, social norms, cognitive set points, and behavioral paradoxes like the Discount/Overspending Paradox will likely affect your choices and undermine your savings goals.

The first step is understanding that “saving money” may not mean what you think it does, but you can learn the right definition and take strategic steps to define the right savings goals for you. The ideas here are a good start.

Savings-related Resources

The Only Budgeting Book You’ll Ever Need

Mint.com

Link to Savings Survey