How to Tell If You're Frugal, Cheap, or Ignorant
Think beyond the initial price tag
Which would you choose if you were offered $1,000 today or $1,100 a month from today?
If you were perfectly rational, you'd choose $1,100 in a month. But since most of us are far from being perfectly rational, odds are you’d take $1,000 right now.
The term “bounded rationality” describes how, when making decisions, people tend to settle for “good enough” rather than “optimal.”
We need bounded rationality to help us make quick decisions. By some estimates, people make up to 35,000 decisions each day. Imagine standing in the grocery aisle weighing every possible pro and con for which brand of tuna you should buy. Most of us buy either a brand we know or whichever can is on sale and move on to the next decision.
But there are some aspects of our financial lives where we should add more rational thinking to our decisions.
Frugal, cheap, or ignorant?
Most of us buy whatever product has the lowest price—and that’s about the only factor we consider.
Does that make us frugal or cheap?
If the price tag is the only factor considered when buying bigger ticket purchases, it’s probably ignorance that drove that decision.
Let’s say you were trying to decide between two different fridges. They are the same size and have identical features like built-in ice machines— but one costs $1,000, and the other costs $1,100. Most people would stop asking questions at this point and buy the $1,000 fridge.
But what if the cheaper fridge uses 25% more energy?
Research has shown that bounded rationality would lead many people to still choose the fridge with the lower price tag even though, in the long run, it ends up costing them a lot more money.
When it comes to big-ticket purchases, think beyond the initial price tag but also consider quality and ongoing costs. The goal should be to minimize the amount you pay per use.
If you spend $250 on a quality pair of winter boots that last 10-winters and your friend pays $75 for a cheap pair of boots, they need to replace every other year—you made the frugal long-term purchase as your cost-per-wear of your boots ends up being a fraction of what your friend paid, despite saving money upfront.
Overconfidence in your financial knowledge can be dangerous—especially for big decisions
A 2015 paper examined how bounded rationality contributes to people taking loans from the following “Alternative sources.”
Payday loans must be repaid within a short period and include a fee of about $15-17 for every $100 borrowed. These loans have very high annual interest rates that can exceed 400%.
Rent-to-own (RTO) transactions let you get stuff without paying the whole cost at once. Say you have bad credit and want to buy a couch. Rent to own lets you buy the couch without having the money upfront. That sounds nice, But it often costs much more than buying it at a store and is marketed toward people with low income and bad credit.
Auto-title loans are short-term loans requiring the borrower to use their vehicle as collateral. These loans have an average interest of nearly 25%, resulting in an effective annual percentage rate (APR) of 300%. They are often available without credit checks or consideration of the borrower's ability to repay, which can lead to revolving debt.
Tax refund anticipation loans are short-term loans that can be repaid by the borrower's tax refund. These loans can be expensive, with high-interest rates. People who use these loans are often younger, have lower-to-middle incomes, and have difficulty getting credit.
Pawn shops offer short-term cash lending to consumers, where the borrower deposits collateral in exchange for a fixed-rate loan that must be paid back quickly. If the borrower doesn't repay the loan on time, they lose their collateral—often a family Heirloom. Interest rates can be very high and vary and are usually between 2% and 25% per month.
All of these loans could be described as predatory in that they are aimed at people with low income and bad credit—meaning they take advantage of the fact that the borrowers often have nowhere else to go for money.
Many of the people who use these loans tend to be younger, have bad credit, and have low incomes. However, the researchers also found that borrowers who were overconfident in their understanding of how these loans worked were more likely to borrow from these non-traditional sources.
How do you stop bounded rationality from impacting your financial decisions?
You don’t. At least, not fully.
Bounded rationality is a feature, not a bug, of the human brain. It’s not something that can be fixed or turned off.
The researchers in the paper I just referenced suggest that financial education can help reduce irrational decisions around money.
It is true that financial education can help reduce overconfidence—but it takes a lot of education and it needs to happen at the right time.
In this article, I dive deep into the “Dunning Kruger Effect,” which describes that people with the least knowledge in a subject are often the most confident and that confidence goes down as knowledge increases. The Dunning-Kruger Effect describes how we are all “overconfident idiots” and why knowing a little bit can be more dangerous than knowing nothing at all.
Financial self-education is useful—but what is more useful is “just in time” financial education. People forget what they learn at a surprisingly fast pace. In this article, I wrote about why learning how different loans work right before you need to take out a loan is the most effective way to make a rational choice.
When it comes to making “the optimal” or a “good enough” financial decision, don’t sweat the small things—but do your homework before making big decisions, even if that means delaying making that choice.
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.