It’s no secret that many Americans struggle to manage their money. In fact, a recent study showed that almost four out of every five Americans live paycheck to paycheck. There’s no doubting this is a serious issue, but why is this the case? Are Americans simply earning too little money to make ends meet? And how can a thing called “nudge theory” save these folks from future turmoil?
Big thanks to Lucas Woodley for contributing this awesome Best Interest post! Take it away, Lucas…
Our Current Problem
By digging deeper into the data, we learn that this isn’t an earnings problem. Ten percent of Americans who earn more than $100,000 per year still live paycheck to paycheck. But, what’s even more interesting are peoples’ views on debt. Almost 75% of workers are currently in debt, and over 50% believe they always will be.
This brings us to our likely culprit: bad financial habits. If you crunch the numbers, people earning $100k a year should have more than enough money to not live paycheck to paycheck. But what if you’re stuck in the habit of spending everything you make? What if you aren’t setting money aside for savings? It won’t matter if you’re earning $10,000 or $1,000,000. Sooner or later, you’re going to find yourself in financial trouble.
How To Break Out Of The Paycheck To Paycheck Cycle
With all of that doom and gloom out of the way, let’s talk solutions. How can you fix these financial habits and set yourself up for success? The answer lies in something called “nudge theory.”
“Nudge theory” originally comes from the field of behavioral economics. The basic idea behind it is that your choices can be influenced, or “nudged,” based on your environment.
Whether you want to increase your savings rate or build a journaling habit, nudge theory will work for you. .
Why Nudge Theory Is Needed
If, for example, you want to lose weight, it’s a lot easier to think about your plan in the future. Many of us have told ourselves, “Starting next week, I’m going to wake up every day at 6am and go for a run” (or whatever your morning routine is). But, when that early morning alarm clock interrupts our sleep, what actually happens? Our groggy selves are often quick to abandon our plans and go back to bed.
What happened? How did something that seemed like such a great idea to our past selves suddenly become so objectionable?
To understand how our brains struggle to estimate future events, imagine you’re holding in your hands a bright red ball. Because the object is right in front of you, you can see it very clearly. If you study it closely, you can probably even see any scratches or imperfections on the ball.
This is how our brain sees the present. Our minds are very good at analyzing situations right in front of us. They are good at giving us a clear picture of everything, both good and bad.
Now, imagine the bright red ball is now thrown the length of a football field. Suddenly, that clearly visible object disappears into the distance. Even though your eyes might still be able to find the ball, it now appears as a small red speck. You can probably make out the overall shape, but those once-clear details have suddenly become undetectable to you.
Just like how an object becomes blurrier as it moves farther away, events and actions become hazier in our minds as they get farther into the future. This is why so much change can occur in just ten years. Our brains are poor judges on that timescale.
As we demonstrated in our exercise example, our brains aren’t very good at predicting how we’ll act in the future. Even if we feel confident in what we think we’ll do, our brains are different when the time actually comes. It’s often much harder to drag yourself out of bed than you would’ve thought last week.
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How To Use Nudge Theory To Make Smarter Financial Decisions
So, what does any of this have to do with saving money or making smarter financial decisions? First, it highlights why so many of us struggle to save for far away expenses like retirement. It’s hard enough to imagine what you’ll want to do a week from now, let alone thirty years from now. Second, and more importantly, it means there are certain things we can do to nudge our brains towards future financial well-being.
Think about our now-stale running example. Knowing what you now know about nudge theory and how our brains suck at predicting the future, you can start to fight against your mind’s natural flaws by setting up a system that makes you stick to your plan.
One possible method is to have a friend be your exercise buddy. That way, the next time you feel yourself wanting to hit snooze, you’ll have someone who can help hold you accountable and keep you motivated. Or maybe you prefer to set your alarm clock on the other side of the room so that you’re forced to get up and out of bed to turn it off.
Whatever you choose, the point is that you’re now actively working to fight against our brains’ weaknesses to make following your future plans easier.
Ways To Make Saving Money Easier
This same concept is also directly applicable to managing finances. There are a ton of different budgeting strategies out there that help force you to follow your monthly budget. For example, the envelope method makes you withdraw a set amount of cash at the start of each month and then divide it up into different categories.
Each envelope holds the designated cash for a certain expense (e.g., “groceries”), and once that cash is gone, you’re done spending in that category for the month.
There are also tons of financial tools that give you helpful reminders about whether or not you’re on track to meet your budget. You can use these methods as simple but effective ways to hold yourself accountable and keep track of how well present you is following your past plans.
If you want to instead help yourself save more money, one of the best ways to nudge your behavior is with automatic systems. Most employers and banks let you get part of your paycheck directly deposited into a separate account.
If you decide you want to save the recommended 15% – 20% of your annual income for retirement, you could choose to have 15% – 20% of each paycheck directly deposited into a retirement account. This means that rather than forcing yourself each month to set aside part of your paycheck, it’s just done automatically. You’d be surprised at how big of a difference this can make in terms of how you view bills and other expenses.
The Big Takeaway
Regardless of how you choose to use nudge theory, be it helping yourself save or learning how to start investing, you’re now aware of why it can feel so hard to stick to a plan. And, most importantly, whether you choose to use automatic programs or self-imposed restrictions, you now have the tools needed to fix your financial habits and set yourself up for long-term success.
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This is exactly what I try to tell my friends when they say they can’t stick to their saving or investing plan! Now I can just forward them this article!
Hey Amanda – yeah, it’s crazy how different people face different challenges when it comes to good habits. My personal example is money and food.
With money, I’ve set myself up with tons of nudges in positive directions. Good money habits are easy for me.
And yet with food, I continue to eat too many salty snacks and sweet treats! I know they aren’t good for me, and yet I can’t kick the habit. I should probably look into some smart food nudges.
My point is…we often KNOW what the good habits are. But it takes some sort of nudge to actually ENACT that good habit.
Anyway, thanks a ton for reading. All the best.