The Psychology of Budgeting

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Budgeting is both logical and emotional, and we shouldn’t strive to be cold-blooded creatures who try to optimize everything. We also don’t want to be utterly unrestrained in every transaction. Both extremes don’t lead to a healthy way of living.

Rarely do things live in silo and are usually affected by many other things. This is why understanding how a budget is tied to psychology can help you gain the self-awareness to help you live your best life.

The first thing that people need to understand about budgeting is how their brain works. In “Thinking, Slow and Fast” by Daniel Kahneman, a book about behavioral economics, he says that the brain has two systems for making a decision.

System 1 is guided by the amygdala and is responsible for fast, intuitive, unconscious thought.

System 2 is driven by the pre-frontal cortex and is responsible for slow, calculating conscious thought.

To help show the difference, try answering this question.

If a bat and a ball cost $1.10 and the bat is a dollar more than the ball. How much is the ball? The answer is at the end of the article.

We need both systems to live a good life. If every decision required a slow, calculating decision, we would never get anything done. If we made every decision on fast and intuitive thought, we would make many errors in our lives, like buying a timeshare in North Dakota.

For some purchases, you want to feel good, like buying a new picture frame for your wall to show pictures of your last vacation, and for some purchases, you have to be logical, like saying no to eating out for the 8th time this week.

I’m not a big fan of setting hard-line items for budgeting, like you should spend 15% of your income on area X and 10% on area Y. Budgets are personal and should be designed to help someone live their best life. As an entrepreneur in his 30s with no kids or partner, my budget is different from someone near retirement, married, and has children in college. The budget depends on the situation and the goals that are trying to be accomplished.

We want to be intentional with our money to take advantage of life and not have life take advantage of us. And the way we can do this is by knowing the rules of your brain and money, so you know which ones to break that can help us live a life worth living.

Here are some psychological tips to help someone design their budget.

Establish A Cool-off Period For Making Purchases

Seeing an ad of someone on the beach or seeing someone’s transformation can give us an emotional response to make a purchase fast. This is why timeshares are so effective. You’re on vacation at the beach. They probably are offering a free meal or some other goodie for you to check out their timeshare. The person will go through their presentation on how the buyer can either rent out their timeshare and make some money or come back to the timeshare and use it for vacation and continue to make great memories.

They don’t tell you right away about the maintenance costs, which will continue for the lifetime of the membership, and the membership doesn’t give you ownership. They want you to make an emotional purchase because the numbers often don’t work out if you took some time to think logically about the decision.

When it comes to renting out the timeshare, who wants to spend time convincing people to rent out their timeshare, not many people will do this, and the timeshare folks know this.

Having a cool-off period for purchases can help prevent your emotions from taking over and have some time to think logically. Say if something is over $50, give yourself 24 hours before you can decide to make that purchase or not. Hopefully, by this time, you realized that you didn’t want this thing and were just excited at the moment.

If you thought about the purchase, still want it, and it makes sense to get it, then go ahead and get the item. There are plenty of past purchases where I wish I had given myself a 24 cool off period and there are plenty of purchases I’m glad I’ve made. It’s about understanding the deal, before you accept the deal.

On vacation, if you budgeted for a $100 meal, then go ahead and spend that money because you were intentional about it. But most likely, you didn’t budget for a timeshare.

Maybe for smaller purchases for under $20, you give yourself a cool-off period of an hour. It depends on your capabilities, what you’re trying to accomplish, and the system you need to succeed with a budget.

Have A Plan That Is Based On Your Goals

The brain secrets four endorphins, dopamine, oxytocin, serotonin, and cortisone, to help us pursue our goals and handle the current environment that we are in. Life requires a lot of endurance, and these endorphins can help us do the right things as we pursue our goals.

To know what is in the best interest of your future self, it requires system 2 to go through its process, but if you’re always on the go, you will default to system 1, which will do things that are in the best interest of its present self.

There might be nothing wrong with the current relationship between system 1 and system 2, but there might come a day where the system needs to change. And system 1 can change what it prefers to do in the present, but it requires system 2 to help rein in the behavior of system 1.

Think of system 1 as an elephant, and system 2 is the trainer on top of the elephant with some reins. If the trainer doesn’t know where to go, why put much effort into controlling the elephant. And if you are constantly tired, the trainer will be too tired to pull on the reins, and the elephant will do what’s best for themself in that time. Like when we say we will go to the gym after work but are too tired to do it because we are mentally exhausted and want a break.

If you have a tangible goal, going to the gym or reviewing your budget can give you a hit of dopamine. It can be painful to go through these things as you pursue your goals, but dopamine masks pain and makes us goes that extra step.

When it comes to going to the gym, suppose you realize that going can help you reach other goals like losing weight so you can have more energy to play with your kids and interact with your partner. In that case, you will be motivated to go through the pain since you will get a dopamine hit if you can visualize how going to the gym will give you the result you want.

With a budget, if you see it as a means to reach your goal, like going on vacation or retiring early, then you will get a shot of dopamine to be motivated to work on that budget and follow through on it.

This is why you should keep the end in mind for the things you want because they can make doing the daily activities easier and write them out so you can visually see them. When I review people’s budgets, I see the big problem is that they are not tied to any goals. They are not sure when they would retire or how retirement would look on their current pace of investing, saving, and spending.

But when we do goal setting and turn them into visual they can see, they seem to be more motivated to go after them. Once you reach your goals, then you get a hit of serotonin which gives folks feelings of well-being and happiness.

There are biological, emotional, and logical reasoning for budgeting, and if you can align all three correctly, you will be unstoppable.

The Cognitive Biases That Shape How Someone Budgets

The brain uses up about 20% of the calories you consume to help make decisions for the day. To help reserves some of this energy, the brain likes to create rules of thumb for making decisions. When I sit down with a new client, I ask them many questions to see what they value and what motivates them, then I ask them how money was for them growing up. How did their parents treat money? How did their family members see money? This typically tells me if someone is a good saver or is a spender and why they have these habits.

Someone should understand the money scripts they are following and see if they should continue to follow them or rewrite them to help them live a better life. A person might always save 20% of their income because that is what their parents told them. They might like to buy nice cars because their parents told them to go after quality since cheaper cars break down faster. These rules can be logical or not logical, but they help the person following them make decisions when there is not enough time or energy to do research.

This is why someone should write down their money scripts and visually see if they still make sense. If they do, then continue to follow them. If they don’t, dare to start changing them.

There could also be cognitive biases that we all have that could cause us to sabotage our budget. I think a big one in budgeting is the Kantian fairness tendency. Something terrible happens, so you do some revenge spending to make you feel better to get a sense of fairness. You might feel better, but you also might have had spent money that shouldn’t have been spent. Here is a list of the other 24 cognitive biases that could affect your budget.

How To Think About Upcoming Payments And Buying Things On Credit

Right now, buy now, pay later services are becoming more popular, and if you see that, you can make six payments of $50/mo to pay for that purchase you want right now. We can get excited about getting the item now versus down the road, and we can get excited about the low payments.

But many small payments can add up if you have five different $50/mo payments, then that $250/mo has to come from somewhere. This is why it’s essential to have a cool-off period. Credit services make it easy to let your emotional side take over and cause you to make purchases that don’t give you the total value you want.

I tell my clients, the price is what you pay, and the value is what you get. Make sure that the value you receive is worth it when making purchases on credit and that you have a plan to pay them off.

Also, make sure that you’re not over-leveraged. Someone living on the margins won’t be ready for an unexpected expense, which can push someone into default. If you needed to pay $500 to $2000 unexpected expense, would you be prepared for it?

If the answer is no, setting aside some money every month should be the first step, but it’s not fun because we do not like losses. Which is another cognitive bias that we deal with, which is to avoid pain and seek pleasure. For most people, budgeting is not as pleasurable as spending money but can be a habit that is adopted if the right goals and system are in place.

Another bias is the over-optimism tendency, where we think nothing will go wrong with the plan, but something most likely will. By having a plan and a nice cushion, that unexpected occurrence can be made into a five-minute problem and not a six month one or longer.

Final Takeaways

Budgeting requires self-awareness, a sense of direction in how you want your life to be, and having the discipline to stick to your money rules. So write out your money rules and understand the money scripts you’re operating from. Then see if you need to update, remove, or add anything.

Then you can use money as a tool to help you pursue your goals so you can live your best life and be in control of it instead of it being in control of you. And according to this study, 65% of Americans are not in control of their money so we need more help in understanding our budgets and how to do them effectively.

For the answer to the logic question above, it is $0.05 for the price price of the ball. Most people will say $0.10 which would make the bat $1.10 then make the total $1.20, not $1.10. We think the math question is simple as 2+2 but it is basic algebra.

As always, please do your research before you make any changes to your financial plan or contact a professional like me to help you out.


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