We all have those friends who are cheap when it comes to some things, and spend a lot on other things. Dan Ariely explains the root of their problem.

Topic: The “drop in the bucket” problem

Dan Ariely: So, part of the problem is the "drop in the bucket" problem. Right? So if I don't have money for health insurance, which is $5,000, what will $5.00 today be. And that's a problem of procrastination. Its $5.00 today and today and today and today, and the problem is, we can't envision to ourselves how this money would accumulate. We have to see where it's coming from. And I think we need visualizing tools. I think actually the banks role is to help us think about money better, and sadly, nobody is doing it because everybody wants us to spend more and more.

I was actually getting a little bit optimistic when the recession hit because banks were becoming interested in getting people to be more responsible. But sadly, I don't see this happening these days. There are a couple of startups, there are a couple of ideas kind of forming around, and I hope there will be some progress, but if you think about a person who is facing this dilemma, it's not humanly possible for him to think about the compound interest and the long term ramification of a latte a day, we need help in that and I hope that software will provide this help.

I also think that the iPhone is a wonderful idea for that. If you think about it, we all have good intentions. Even you friend who is spending the $5.00 on the lattes, they have good intensions for the long term, only in the short term, it's very hard to act on these good intentions. And I find this interesting because it can be with us when we have long term plans and when we have short term failing. And if you think about the phone as a time machine in this case, I think it could help you.

Topic: Taking the outside perspective

Dan Ariely: I'll tell you one more application. This is the first app we're going to have out, we'll have it up, I hope in two weeks if Apple approves. And you go on the iPhone and you pick four people that you admire, that you respect and you pick them from your address book. And then when you're tempted with something, you say what you are tempted with and then you pick one of those people and you say, what will they have told me to do? Now, what's the idea here? The idea is that when we are in a situation, it's very hard for us to take the outside perspective. But if you say, what would your mother tell you to do? And then you click, "I'm tempted to buy coffee; I'm picking my mother -- what would my mother tell me. I think my mother would tell me "No." And then it also sends it to your mother to verify. Now, you don't have to wait for your mother to verify to figure it out, the idea is to give people the outside perspective, to get them to think a little bit about, as advisors to themselves.

What we find, not in this app, but in general in experiments, is when people take the role of advisors, they become more rational. They see the long term more than the short term, they are less committed to the emotion of the moment, and they can do better.

Now, will w have one solution? No, I don't think so. I think we will have lots of solutions, but I think we are at the start of developing some software, some pre-commitment devices, some more awareness, and I'm actually optimistic that we will become better and better at this.

Topic: The problem with loans

Dan Ariely: There is another question about how people decide what loans to pay first. So, we're assuming right now in this discussion that people have money and it's a question of saving versus spending, what happens to people who have lots of loans?

So we recently did this study that asks the question of how do people decide what loans to pay first? And sadly what we found out was that people paid the small loans fore they paid the big loans. So, imagine you have six loans, small to huge. People want to close loans and because of that, they try to pay off the small loans, but that's not the right strategy. The right strategy, of course, is to pay the loan with the highest interest rate. People make this mistake and it costs them lots and lots of money, it's a very expensive mistake because interest rates accumulate and become very, very expensive very quickly.

We also find in our experiments that too many people these days, when they have cash, they keep too much cash in reserve. And it actually looks like a two stage process. People decide how much cash to keep, for a rainy day, and then the rest they allocate between loans, and over time, they learn a little bit about how to allocate the loans so that they pay first the high interest rate, they don't learn perfectly, but a little bit. But they still keep too much in cash and interestingly these two mistakes are connected. The people who keep more cash also tend to be more mistaken in how they allocate loans. And this, I think is a couple of really big mistakes. First of all, people should figure out very quickly how to pay loans fast and they should do it well because it's so expensive to have loans.

The second thing is I think at this time in history, when we are so uncertain about everything and everybody gives us advice about keep six month’s salary in cash. This is good advice to some people, but it's not good advice to people who have loans. Because, if you have loans, the first thing you want to do is say, "Okay, look I have a credit card, if I really need to borrow, I have this emergency money that I can get, but for now there is no reason for me to keep cash at zero percent interest rate and at the same time, pay all of this money out. So, I think people need to figure out quickly how to pay loans and how much cash they should really keep.

Recorded on November 16, 2009