Financial heuristics: Creating money rules to live by –

  • April 13, 2015
  • By: Greenpath Financial Wellness

Credit Card

We all have financial rules that we live by. Some help us save money, such as a policy of waiting 24 hours before making an impulsive purchase. Other rules end up costing us, such as a tradition of rewarding yourself with a new gadget whenever you land a new client.

There’s a psychological term for making rules or “shortcuts” that speed up problem-solving and simplify decision-making: heuristics. People who create effective heuristics tend to have more financial success because “they have a disciplined approach to their finances,” says Hersh Shefrin, a professor of finance at Santa Clara University’s Leavey School of Business and co-author of the study “Credit Card Behavior, Financial Styles and Heuristics.”

The key to using heuristics successfully is knowing your financial end game and creating a set of rules that will get you there. Here are nine steps that will make the process easier than you think.

  1. Identify the rules you already use. Chances are there are heuristics that are already governing your spending, such as paying off your credit card balance in full each month or only making the minimum payments. When you review your monthly spending, jot down why you made the financial decisions you made, Shefrin suggests. The insight into your financial thought process will help you identify when your rules need to be tweaked.
  2. Start with where your budget falls apart.Most of us don’t overspend on our mortgage or car payments. It’s the day-to-day purchases such as groceries and coffee runs that mess us up, saysKathryn Bossler, financial counselor for GreenPath Financial Wellnessin Detroit. When creating rules that work, start with those areas where you need the most discipline to guide your spending.
  3. Focus on your weaknesses. If you’re already strong in a particular type of money management, you may not need a heuristic that addresses it. For example, if you never run up credit card bills, don’t waste time creating a rule that governs credit card spending. On the other hand, if you always go over your budget, you might create a cash-only policy in which spending stops when the cash runs out.
  4. Make your rules personal. The financial rules your neighbor goes by may not work for you. For example, many experts suggest that you save 10 percent of your income, but “for some people that’s not realistic,” Bossler says. “Maybe they can only afford $10 a check.”
  5. Take the emotion out of it. Our money habits can be governed by emotions, says William Marty Martin, a financial psychologist and associate professor in the Department of Management at DePaul University.  For example, you may blow your budget whenever you’re mad at your boss. If you know that certain feelings trigger your spending, that’s where you need to create a rule. Then, “you know what you need to do even when you experience a state of heightened emotions,” Martin says.
  6. Create some flexibility. If a heuristic is too rigid, it doesn’t account for the unpredictability of life. Joan Fradella, an accountant in Lantana, Florida, has a rule in which she only buys items that are on her shopping list. However, she has an uncommon shoe size, making it difficult for her to find well-fitted shoes. So even though it breaks her general rule, “I have permission to get more than one pair in different colors.”
  7. Simple is often better. Too many rules can be counterproductive. If you’re trying to follow too many different criteria, you may get “decision fatigue,” Martin says. If that happens, don’t be surprised if you give up on your efforts entirely.
  8. Allow your heuristics to evolve. Just because a rule of thumb works today doesn’t mean it will work tomorrow. For example, if you have credit card debt, you may have created a rule in which you always pay $5 more than the minimum payment because that is all you were able to afford at the time. But if you get a raise and have more money to put toward your debt, you could be hurting yourself financially if you don’t adjust your rule to account for your new financial reality. You also might need to change a rule when there is evidence that it’s not working, Martin says.
  9. Get an accountability partner. Having a rule in place only works if you’re going to follow it. Having someone to stay accountable to can help you to actually enforce your heuristics. Tammy and James McDonald of Pearland, Texas, never spend more than $100 without the approval of the other, Tammy McDonald says. “These established rules played a part in helping us keep our home when my husband was forced in to medical disability.”

Heuristics are key to creating a financial plan that will endure. “You want to have good heuristics in place because you want to cultivate good habits for spending and borrowing over the long haul,” Shefrin says.