Can People Really Change Their Financial Behavior?

I’ve been writing a lot lately about personal finances because it seems like every week another report comes out showing how ill-prepared people are when it comes to their financial situation. My friend James Osborne asked me if I really think people can be taught to live within their means. I do think it’s possible, but it people have to learn how to implement systems and change how they think about their finances.

In one experiment, researchers split a larger group of people into two separate groups. They asked half of the subjects whether they thought they could save 20% of their income. Only half of this group said yes. But when they asked the other group whether they could live on 80% of their income, nearly 80% said yes.

Another study looked at workers that were paid every five days. Researchers broke out their paychecks into six equal envelopes, one to spend each day, plus an extra. Even though it was the same exact amount, just split up differently than before, the savings rate increased fourfold simply because people viewed the 6^th envelope as extra money, and were more likely to save it.

One of the reasons it’s difficult for some to live within their means is because it’s so easy to allow your spending to outpace your savings rate, even when you start to make more. Dr. Jim Dahle writes a great blog called The White Coat Investor that focuses on financial advice for doctors, but the majority of his advice is universal. In an interview last week he talked about one of the biggest aspects of being able to live within your means — lifestyle inflation. He said there are two types of doctors in the sixties — those who are rich or those who basically have nothing. It all depends on when (or if) they started saving. His solution is to live like a resident early in a doctor’s career for a few more years to jump-start your finances:

Now, a typical medical student graduates from medical school with all this debt.  About $200,000 is the average right now of people that came out in the last year.  And then, for three to five years as a resident, they’re making $40,000 to $55,000 a year. And what I tell them to do is when they finish residency, for two to five more years, keep living on that same resident salary, spending $40,000, $50,000, $60,000 a year. Maybe give yourself a little bit of a raise. But if you come out of residency where you were making $50,000, and now you’re making $200,000 or $250,000 a year.  If you can just keep your lifestyle the same for a few more years, you can take the difference between those salaries, pay off all your student loans, jump start your retirement savings, save up a down payment for that big doctor house you want, and all of a sudden, your finances are on easy street just five to ten years out of residency, whereas far too many doctors just grow straight into their income.

Being content with your current standard of living is probably one of the best ways best ways for people to save more money, which can be supercharged when you start making more as your career progresses. I’m also a fan of saving a certain percentage of your raise every year. A good rule of thumb is to make yourself save at least half of every raise each year and enjoy the rest.

There are a number of little tricks like this you can implement to try to save more, but it’s impossible without a long-term system to make it repeatable. Trying harder to save more or pay your bills on time is not going to help. You need to automate these tasks to make them stick.

Living within your means is also not something you can do all at once. You can’t go from sitting on the couch all day to running a marathon. It’s going to be difficult for someone to go from saving nothing to saving $500/month. When you set huge goals it’s much easier to give up on them because they seem so impossible when you fall short right out of the gate. But if you start small, say saving $50-100/month, you can slowly build up to your ultimate goal and spread the pain of loss aversion over time.

There will always be certain people that either aren’t able or willing to live within their means. For everyone else, I think it’s possible, but not without the ability to build financial systems for yourself, keep your lifestyle inflation in check and re-frame how you think about your finances.

Sources:
The White Coat Investor: Investing for Physicians (The Lange Money Hour)
Why Smart People Make Big Money Mistakes and How to Correct Them

Further Reading:
How Framings Affects Investment Decisions & Outcomes
Stressing Out About Money
“I have a high tolerance for repetition”

Now here’s the stuff I’ve been reading this week:

• When investors try too hard to get things right (Bason)
• Maybe the baby boomer generation wasn’t so obvious (Morgan Housel)
• Go through your fund selection process with a bushwhacker (Kathryn Cicoletti)
• Diversification is actually working (Reformed Broker)
• The relationship between stock and bond returns (Econompic)
• How advisors can capture business from millennials (Convergex)
• 5 retirement planning issues to consider (Aleph Blog)
• A great list from Finance Twitter on the worst rules of thumb about the markets (Economic Musings)
• Why self-reflection can be so painful and enlightening (Research Puzzle)
• Human innovation is winning (Prag Cap)
• 9 money myths experts wish you would stop believing (Boomer & Echo)
• Also, check out yours truly in the New York Times this week in a piece about the 60/40 portfolio (NY Times)