You know you're not supposed to keep up with the Joneses, but there's a downside to even judging their habits. As personal finance expert Carl Richards explains, when we make assumptions about the way other people save, spend or earn money, it can negatively affect our own financial decisions.
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James Duesenberry, an economist and consumer researcher, called it the relative income hypothesis. It's our tendency to use other people as a frame of reference for our own decisions and attitudes about spending and saving money. Here's how Richards explains it:
According to Mr. Duesenberry, people tend to save less "because the higher spending of others kindles aspirations they find difficult to meet." He also argued that "the high standard enjoyed by a formerly prosperous family … constitutes a frame of reference that makes cutbacks difficult."
Just think about that for a second. We base our decisions about how we spend our money on how we think our income compares with those around us and what we've spent in the past. But unless our neighbours have shared their tax returns, we don't know their real income. Our financial decisions could easily be based entirely on fiction.
I'm guilty. For years, I saved for retirement based on what I thought my friends were saving. And since I assumed they were saving nothing, I didn't save nearly as much as I should have been. Rather than use my own goals as a guideline, I used my assumptions about their savings habits as my frame of reference. Richards puts it this way:
...not only do we have a habit of telling ourselves fiction about the people around us based on outward appearances, we also allow those stories to inform how we spend our money.
Like a lot of money issues, it's a sneaky habit you may not even pick up on. Simply being aware of it can go a long way, but Richards offers some additional steps to avoid it in the full post at the link below.
Ignore the Fiction — Stop Spending Based on Stories [Behaviour Gap]