Don’t Forget This Secret Ingredient in Your Budget

Don't Forget Slack Budget Header ImageAre you pressed for time? How about money?

If you’re like most of us, you probably feel the strain or one or the other, if not both. In this day and age, it just never seems like there’s enough time in the day or enough money in the bank.

But did you know that your feelings of scarcity might be harming your ability to make good financial decisions? Read on to learn about the intellectual effects of the everyday stress of scarcity — and how to combat it with one critical line item in your budget.

The impact of scarcity on decision-making

You might intuitively sense that stress, time pressure, and financial worry could complicate decision-making, but the effects are more potent than you might think.

Princeton University psychologist Eldar Shafir and Harvard economist Sendhil Mullainathan have collaborated on several studies that shed light on just how powerful scarcity is. Their finding? We literally become less intelligent when we feel that time or money are in short supply.1

For example, in one study, Shafir and Mullainathan asked mall-goers in New Jersey to complete an IQ test while thinking about a hypothetical situation in which they had to pay for car repairs. When the cost of repairs was relatively low, both wealthier and poorer people performed equally well. But when the researchers raised the price of the repair into the thousands of dollars, the performance of the poorer participants plummeted.

In other words, people who were already experiencing financial pressure had a harder time performing at their best when that pressure was magnified — even hypothetically.

To test the reliability of the study (as there could have been differences between people that weren’t being observed), the researchers took their work to India, where they gave IQ tests to sugarcane farmers at two different times of the year: a couple of months before the annual harvest and a couple of months after.

Depending on the time of year — in the cash-strapped phase or in the flush period after the harvest — the farmers’ scores varied by the equivalent of about 10 IQ points. In other words, the same individual farmer had a lower IQ when he was poor than when he was wealthy.

The results show how difficult it is to rise to the occasion when you’re under financial pressure, and Shafir and Mullainathan’s work shows that it doesn’t really matter what the occasion is. Whether it’s a budgeting decision, a loan, or an IQ test, your performance will likely suffer when you’re feeling the effects of scarcity.

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How does it work?

The results are driven by a process that psychologists call “tunneling.”2 When preoccupied with a problem — how to pay the bills, manage debts, deal with a job loss, etc. — we have a tendency to focus on that single problem at the expense of everything else.

If you’ve ever laid awake into the night trying to get a handle on your to-do list or found yourself staring into the refrigerator (again) after starting a new diet, you probably know what this feels like.

Tunneling isn’t just energy-consuming: because it focuses your brain on one thing, tunneling diminishes your intellectual capacity in other areas — including some of the basic features of good decision-making. With reduced attention, self-control, and planning abilities, worry about finances can quickly spiral into a series of poor decisions that build on each other and cause even more worry.

Unfortunately, it’s surprisingly easy to end up in this kind of situation.

As Professor Mullainathan put it in an interview with Harvard Magazine, “If I made you poor tomorrow, you’d probably start behaving in many of the same ways we associate with poor people.”

One of his studies with Professor Shafir showed how easily it can happen. Princeton University students were put into an experimental setting that mirrored the potential debt spiral of payday loans, only the researchers manipulated the presence of time instead of money. Just as predicted, the students quickly fell into the trap of subjecting themselves to escalating and increasingly unmanageable debts — just like payday loan customers.3

What can I do?

The difficulties that arise from stress related to scarcity offer a valuable lesson: the critical importance of building savings.

While it’s hard to imagine siphoning off a large amount of money to savings (especially when you’re under strain already), most of us can rethink our spending. Even if its just a few extra dollars here and there, don’t underestimate the value of building “slack,” as Professor Shafir calls it. The savings you have can give you a more flexibility to deal with the inevitable inconveniences of everyday life, as well as reduce some of the intellectual stresses of scarcity.4

In other words, build a buffer into your budget.

It’s the secret ingredient that could help see you through a tough financial moment or help smooth the edges of a bad day. It doesn’t matter if your monthly savings is $20, $200, or $2,000: figure out what you can afford and then, critically, follow through.

The amount may seem small today, but it will build, and you’ll be thankful for your “little extra” later. Whatever your situation, you are pretty much guaranteed to stumble into a financial surprise at some point in your life.

Make it more manageable by making savings a priority — not only will it help you pay, it might even help you sleep.

Let Us Help!

We can discuss this topic and more in person at a complimentary appointment. As a bay area retirement specialist we can give you a review and make suggestions based on your retirement objectives.

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1 This section: Cara Feinberg. “The Science of Scarcity.” Harvard Magazine, May-June 2015. http://harvardmagazine.com/2015/05/the-science-of-scarcity

2 All information on tunneling: Amy Novotney. “The Psychology of Scarcity.” American Psychological Association Monitor, February 2014. http://www.apa.org/monitor/2014/02/scarcity.aspx

3 Thsi section: Cara Feinberg. “The Science of Scarcity.” Harvard Magazine, May-June 2015. http://harvardmagazine.com/2015/05/the-science-of-scarcity

4 Amy Novotney. “The Psychology of Scarcity.” American Psychological Association Monitor, February 2014. http://www.apa.org/monitor/2014/02/scarcity.aspx

Disclosures

The opinions voiced in this article are for general information only. They are not intended to provide specific advice or recommendations for any individual and do not constitute an endorsement by United Planners. To determine which investments may be appropriate for you, consult with your financial professional. Please remember that investment decisions should be based on an individual’s goals, time horizon, and tolerance for risk.

Neither diversification nor asset allocation can ensure a profit or prevention of loss in times of declining values.

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