smart spending

7 psychological money traps and how to avoid them

When it comes to handling money, most of us aren't as rational and logical as we think. As with losing weight, we know what we need to do -- eat less (spend less) and exercise more (save more), but somehow we can't bring ourselves to do it. Or we buy a hot stock that really doesn't fit our investing needs and later wonder, "What the heck was I thinking?"

You needn't beat yourself up about your seemingly irrational money choices, though -- it turns out there's a lot of psychology and evolutionary history involved in why and how we do dumb things with money.

In fact, there are now entire fields -- neuroeconomics and behavioral economics -- dedicated to how and why we behave certain ways with money. The good news is that researchers in these fields have pinpointed ways we can actually outsmart our brains when it comes to money. We simply need to understand the most typical financial/psychological traps, then shift the way we make certain investing and purchasing decisions.

1. The lure of free 

No matter how smart you are, that one little word can lure you to make purchases you wouldn't have otherwise. In fact, it happened to Dan Ariely, the Alfred P. Sloan Professor of Behavioral Economics at MIT and subsequently the author of "Predictably Irrational: The Hidden Forces That Shape Our Decisions." Ariely confesses that he uses his own mistakes to inspire his research.

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Not long ago, Ariely says, he passed up buying a much-needed minivan in favor of a sporty Audi. Why? There were a few other factors, but a big influence was that the Audi came with free oil changes for the next three years. "In fact, those services were only worth about $200, but the promise of 'free' anything was very appealing," he says. "They could have offered me a $2,000 discount on the minivan and I still would have bought the wrong car (the Audi) because the free oil-change offer was so tempting in the heat of the moment."

According to Ariely, that simple word "free" also explains why consumers will choose a "free" credit card (no annual fee) with an annual interest rate of 15 percent over a card with a $100 annual charge but a lower interest rate of 12 percent.

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