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1. This ain’t your typical personal finance blog. I don’t often tackle the basics of a Roth IRA or how to choose a money market account. I do write about the cutting edge of behavioral finance and how it affects the choices you make.
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Not going to lie: I’m not a huge Dave Ramsey fan.
There have been several times he’s spoken on radio or I’ve seen things he’s written in print where I thought he was flat out wrong or misleading on a point. One of my recurring favorites is how he encourages people to take what they save and put it into a “good growth stock mutual fund that earns 12% on average.” Man, if only it were that easy.
Another one of his non-sensical strategies is also one central to the Ramsey philosophy. The “debt snowball” debt payment plan is completely contrary to basic rules of arithmetic. You see, Ramsey says that if you have a bunch of credit card debts, you should line them all up by the size of each debt, and pay the smallest balance ones off first, regardless of their interest rates.
The rational person in us should cringe at this. The size of individual debts shouldn’t be the driving force. If a $20,000 debt has a 15% interest rate and a $3,000 debt only has a 4% interest rate, you’re going to be paying more interest if you pay off the smaller debt first.
But Ramsey has a lot of experience talking and working with us humans and knows that’s not how we think. We derive pleasure from small wins. So “closing out” a little debt feels like more progress than putting a little dent in a big debt.
I don’t think he studied it empirically, but luckily, we have behavioral economists for that…
MBA students like the debt snowball, too.
Duke’s Dan Ariely actually ran a snowball-like experiment himself. He gave a group of testers a set of five, fictitious loans and a fake salary to pay them off. At the end of the experiment, they got to keep whatever money they had left over.
The “solution” to the experiment—that is, the method that made the subjects the most money—was to pay off the highest interest rate loan first, followed by the lower interest-rate loans with no regard to loan size.
Problem is, none of the test subjects did that. According to Ariely not one of more than a thousand people did that, including some testers who were MBA students.
Ariely’s takeaway, in his interview about it anyway, was that things can and should be done to take away the incentive to “close out” a loan. If you didn’t allow someone to close a loan, for example, people became rational and paid the big one first.
My takeaway, and this is similar to what Ramsey says, is that building those little wins has a psychological benefit that outweighs the extra interest the debtor pays on those small loans with high rates.
If that small win means a debtor keeps paying down debt, instead of giving up out of frustration, it’s a “win” even if he makes the irrational choice.
The theory of “Small Wins”
Ok, so let’s say you’re trying to tackle a big problem. No, not patching the hole in your roof. That’s too small. Really big, like patching the hole in the ozone layer. How are you going to go about doing that?
Just makes you want to shut down and continue playing Angry Birds, right? For a while, management and psychology gurus have posited that in the face of big challenges with complicated solutions, we tend to shut down and give up.
In a classic 1984 article, Karl Weick proposed that to tackle big social issues, we ought “to recast larger problems into smaller, less arousing problems, [so] people can identify a series of smaller controllable opportunities of modest size that produce visible results.”
So telling someone to tackle the ozone problem is pointless. Telling someone to reduce their greenhouse gas emissions by 30 pounds of CO2 is a little better. But telling someone to replace their incandescent lightbulbs with fluorescents…now we’ve got something we can wrap our heads around.
The same can be seen in your office or school. A little pat on the back to a new employee— “Hey James, nice work on that report. You really sold the plan well.” —builds confidence and increases James’s engagement with whatever the next project is.
Applying a small wins strategy to your finances
Aside from the debt snowball, I can see a number of places where a small-wins strategy could give you the psychological boost needed to get a big goal accomplished.
1. Always break down big goals into concrete outcomes of moderate importance.
That’s ripped almost straight from Weick’s article. But the point is this: Big goals are worthy, but not doable. It’s the dozens of small goals that lead up to it that our brains can tackle.
The best goals can be accomplished in a couple hours or even a couple of minutes. For a big goal, try building a work-flow chart that leads from the small goals to the big one.
For example, say I want “to apply to law school.” Big goal, lots of steps.
A smaller goal: To get recommendations from my professors.
The best, smallest, and most accomplishable step: E-mail Professor Thompson to ask for a recommendation letter today.
2. Reward yourself for the small wins.
Ariely proposed taking away the reward from paying off a small debt. If you can’t close the loan, he said, you won’t be misled into paying the small ones off first.
It seems the same thing could be accomplished in a positive way. If you have a big credit card debt, why not break it down into each item the went into it?
For example, within your $5,000 debt, maybe $1,200 was a new computer, $400 was a trip to Macy’s, and $600 was an emergency plane ticket home.
Now, when you pay the debt down by $500, you can cross that Macy’s trip off the list and feel like you accomplished something, even though the larger debt didn’t go down by much.
I have a negative incentive myself to post twice per week. If I don’t write two posts, which builds Pop Economics toward a comprehensive behavioral finance blog, I get charged $100 as a penalty. A positive incentive would no doubt make me happier, but I haven’t found one as immediate or effective as the financial penalty.
3. Don’t let reason get in the way of letting good things happen.
Yes, the debt snowball is irrational. However, it’s not bad. It works. Consider the money you’re losing in higher interest payments to be the fee you pay to actually pay off your debt once and for all, just in the same way it’s cheaper to quit smoking cold turkey but nicotine gum might be the more expensive, but better, option.
A lot of very big things can happen if you take the right small steps.
Hat tip to Karen from MSN Smart Spending for pointing me to the Ariely interview.
{ 5 comments… read them below or add one }
Small wins and very small changes are huge. I don’t know about paying off debt since I don’t have any anymore except for the mortgage that’s going away this year. I took the same approach to savings though by celebrating every $2.5k (~ a month of retirement expenses bought) I saved up.
When I was pushing for retirement / semi-retirement, I looked at everything I spent in terms of “how many days of retirement would this buy me if I forego the purchase?” It was easy to wrap my head around rather than thinking of how I would save up hundreds of thousands of dollars.
Big fan of Ariely, but in following the link, I had to wonder – is this just a case of people being bad/scared of math? As a rational person, sure, you shoot for the high interest rate loans first. But, in this experiment, and forgive me if it’s right in front of my face and I didn’t see it, did the participants do the math on what the costs of both strategies would be? Or were they told what the final totals would be? I find calculating what I owe and how interest accumulates to be very difficult, especially over time when the remaining principal changes, or when interest compounds. If I was a participant in an experiment for an afternoon, and was told “you can do this or this” and had no scrap paper to work out the figures, well, I’d probably just shoot for knocking some of the debts out of the game early, too, but only in the ABSENCE of information about the total cost of each strategy. Personal finance is easy; it’s the front-loading of the math that’s hard for me.
I think that dave stumbled upon the real secret to success with the debt snowball, and it’s that money is in the psychology. I tried for 3 years to “pay off my debts” but never made (visible) progress and then gave up. When I looked at starting my debt snowball, my smallest debts were the highest interest, so that just made sense (all credit cards). Now I’ve disposed of those, the math gets a little trickier. Do I continue with the smallest amount, or move onto something with a higher interest rate? Now that I’ve paid off 4 debts, I know that I can do it, so the mental game is there.
I know the debt snowball doesn’t make much mathematical sense, but if they were worried about making the math right, they wouldn’t be in debt in the first place!
As far as I’m concerned, whatever method people use to pay off debt that works is great. Just as long as it works.
@Jacq: That’s a great way to go about saving for retirement. It changes an obscure and intangible goal into something you can actually visualize.
@Monty: I’m sure the participants had the opportunity to calculate the interest payments, but I don’t know if Ariely tracked whether or not they did. It doesn’t seem like you’d need pencil and paper to understand that a loan with a 15% rate costs more than one with an 8% rate, but you’re right, math skills are pretty bad in this country. It’s telling though that not one of the participants paid off the loans in a way that was most cost effective. To me, that suggests there must be something else going on besides poor math skills.
@Jeff: Great story and glad it worked for you.
Yes, the debt snowball is irrational. However, it’s not bad. It works.
The way I would say it is that the debt snowball is “illogical.” My take is that it cannot possibly be irrational if it works. The rational thing is to take money steps that work.
The root problem is that the conventional economic models ASSUME rationality on the part of human actors. You cannot get to first base if you build your house on such an assumption. There is no such thing as a 100 percent rational human. So it is impossible that any money advice rooted in the conventional economic theory (and that’s most of it) could ever work.
Some find this reality depressing. I do not. My take is that accepting the fundamental irrationality of the human actors will permit us to achieve the greatest advances in our understanding of personal finance topics ever seen in history. Getting real is all good, with no possible downside (except for the “experts” who are just too darn lazy or too darn proud to rewrite their out-of-date books).
Rob
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