We have been fascinated for a long time by the study of behavioral finance, which seeks explanations for the decisions that people make when faced with a financial dilemma. In the course of this field of research, many tests have been done that highlight how easily a person's financial decision-making can be swayed by other factors.

 

Why is it so easy for people to make the wrong financial choice? There are two broad reasons. First, consumers don't always know the real value of what things should cost. And second, because people don't know the real value of the item or service in question, they rely on various kinds of clues to formulate a decision. As a result, the best mathematical choice is often disregarded. Here are a few examples:

 

(1) Getting something extra "for free" feels better than getting the same for less.

 

You walk into a Starbucks and see two deals for a cup of coffee. The first deal offers 33% extra coffee. The second takes 33% off the regular price. What's the better deal?

 

"They're about equal!", you'd say, if you're like the students who participated in a new study published in the Journal of Marketing, you'd be wrong. The deals appear to be equivalent, but in fact, a 33% discount is the same as a 50 percent increase in quantity. Math time: Let's say the standard coffee is $1 for 3 quarts ($0.33 per quart). The first deal gets you 4 quarts for $1 ($0.25 per quart) and the second gets you 3 quarts for 66 cents ($0.22 per quart).

 

(2) We're heavily influenced by the first number.

 

Remember a few years ago, when your home was probably worth a great deal more than what it would sell for today? Many people hang on to that figure as the real value of their home, setting their target on getting that number when the time comes to sell. In behavioral finance, this is called anchoring.

 

The same type of thing may happen when you walk into a high-end store and you see a $7,000 watch. You say to yourself, "I'd never spend that much on a watch!" But then you spot a similarly-fantastic watch for $367. Compared to a Timex, that's wildly over-expensive. But compared to the $7,000 price tag you just put to memory, it's a steal. In this way, stores can anchor your expectations for spending.

 

(3) We're terrified of extremes.

 

We don't like feeling cheap, and we don't like feeling duped. Since we're not sure what things are worth, we shy away from prices that appear too high or too low. Stores can employ our bias for moderation against us. Here's a great story:

 

People were offered 2 kinds of beer: premium beer for $2.50 and bargain beer for $1.80. Around 80% chose the more expensive beer. Now a third beer was introduced - a super bargain beer for $1.60 in addition to the previous two. Eighty percent bought the $1.80 beer, and the rest the $2.50 beer. Nobody bought the cheapest option.

 

Third time around, they removed the $1.60 beer and replaced it with an upper premium $3.40 beer. Most people chose the $2.50 beer, a small number cose the $1.80 beer, and around 10% opted for the most expensive $3.40 beer.

 

(4) We're in love with stories.

 

In his book Priceless, William Poundstone explains what happened when Williams-Sonoma added a $429 breadmaker next to their $279 model. Sales of the cheaper model doubled even though practically nobody bought the $429 machine. One explanation for why this tactic works is that people like stories or justifications. Since it's terribly hard to know the true value of things, we need narratives to explain our decisions to ourselves. Price differences give us a story and a motive: The $279 breadmaker was 40% cheaper than the other model - we got a great deal! Good story.

 

(5) We let our emotions get the best of us.

 

In a brilliant experiment from Poundstone's book, volunteers are offered a certain number of dollars out of $10. Offers seen as unfair ($1, let's say) activate the insular cortex, "which is otherwise triggered by pain and foul odors." When we feel like we're being ripped off, we literally feel disgusted - even when it's a good deal. Poundstone equates this to the minibar experience. It's late, you're hungry, there's a Snickers right there, but you're so turned off by the price, that you starve yourself to avoid the feeling of being ripped off. The flip side is that bargains literally make us feel good about ourselves. Even the most useless junk in the world is appealing if the price feels like a bargain.

 

(6) We love getting rebates and warranties.

 

Although most people avoid additional transaction costs, there are two additional payments we love: rebates and warranties. The first buys the illusion of wealth ("I'm being paid money to spend money!"). The second buys peace of mind ("Now I can own this thing forever without worrying about it!"). Both are basically tricks. "Instead of buying something and getting a rebate," Poundstone writes, "why not just pay a lower price in the first place?".

 

"Warranties make no rational sense" Harvard economist David Cutler told the Washington Post. "The implied probability that a product will break has to be substantially greater than the risk that you can't afford to fix it or replace it. If you're buying a $400 item, for the overwhelming number of consumers that level of spending is not a risk you need to insure under any circumstances".

 

(7) We're obsessed with the number 9.

 

Up to 65 percent of all retail prices end in the number 9. Why? Everybody knows that $20 and $19.99 are the same thing. But the number 9 tells us something simple: This thing is discounted. This thing is cheap. In other words, 9 has become a message of silent understanding between buyer and seller that a product is being priced competitively and fairly. Remember, shopping is an attention game. Consumers aren't just hunting for products. They're hunting for clues that products are worth buying. In the number 9, the bargain-hunter/discount-gatherer corner of our brain spots a pluckable deal.

 

(8) We're compelled by a strong sense of fairness.

 

The consumer's brain is motivated by a sense of fairness. Again, it comes back to the idea that we don't know what things should cost, and so we use cues to tell us what we ought to pay for them. An experiment by the economist Dan Ariely tells the story beautifully. Ariely pretended he was giving a poetry recital. He told one group of students that the tickets cost money and another group that they would be paid to attend. Then he revealed to both groups that the recital was free. The first group was anxious to attend, believing they were getting something of value for free. The second group mostly declined believing they were being forced to volunteer for the same event without compensation.

 

What's a poetry recital by a behavioral economist worth? The students had no idea. That's the point. The same could be said for other items and services - what's a button-up shirt worth? What's a cup of coffee worth?" What's an insurance policy worth? Most of us don't have any idea how to value these things without some kind of indicator, such as visual clues, triggered emotions, comparisons, ratios, and a sense of bargain vs. rip off.