Would you walk for 20 minutes in the sun to save $10 on a $20 iPhone cover?
Would you walk for 20 minutes in the sun to save $10 on a $1,500 MacBook?
Most people are more likely to say “yes” to the first scenario and “hell freakin’ no” to the second. That doesn’t make sense though – in both scenarios, you’re walking for 20 minutes to save $10. So why is it so much easier to say, “Ahhh… heck it!” when it comes to the MacBook?
It’s because of a tiny little piece of psychological hardwiring in our brains called mental accounting, or the tendency to handle money differently depending on where it comes from, where it is kept, or how it is spent. Readers of my free ebook would have briefly encountered this little son of a bitch, but today I’m gonna lay out the definitive guide on how it can screw your life – and what you can do about it.
Mental accounting: Whazzat?
My strict, middle-aged, Economics professor in college would have told you that money is fungible: $10 in savings, $10 in roulette winnings, and $10 to walk for 20 minutes should all mean the same to you. After all, each $10 can be used to buy the same number of iTunes downloads, the same number of MRT rides, and the same number McDonald’s nuggets (but I recommend eating no more than 6. I ate like 20 last week and nearly died).
But my Economics professor was wrong (Been waiting to say that for years, Professor Stein!). People aren’t machines. Instead, they separate their money into different mental “accounts” – treating the money in one account differently from another.
Take your bonus, for example. When most people get their bonuses, they plonk it into a mental account labeled “Spend like a maniac to make up for your unsatisfying corporate life”. That’s why the people who normally eat at hawker centres to save $3 for dinner are the same people who will blow their $3,000 bonus on holidays and cars and Louis Vuitton underwear (Does that even exist? I have no idea – my underwear’s from the sale rack at OG).
What Your Insurance Agent Doesn’t Want You to Know
Or take insurance agents (I know you guys call yourselves financial planners these days, but you aren’t kidding anyone). An insurance agent will first get you to agree to buy an expensive, whole-life policy costing you $200 a month. He’ll then craftily slip in a rider: something you can add on that will cover you for specific scenarios, say if you ever get injured by a falling refrigerator. You can add this Falling Refrigerator Cover for a low, low price of just $20 a month – that’s just 10% of what your original policy costs! Here, your agent is lumping that additional $20 into the same mental account as the original $200 you agreed to, making it seem cheaper than it actually is.
The Dark Side of Credit Cards
Or let’s take the ultimate mental accounting hoax known to man: Credit cards. Because credit cards seem to devalue dollars, they increase the likelihood that you’ll spend more when you use them than you would if you were paying cash. In an experiment, students participated in a real-life, sealed-bid auction for tickets to a Boston Celtics game. Those who were told that they were to pay with their credit card if they won ended up bidding twice as much as those who were told to pay with cash.
What You Can Do About It
1. Separate that shizz
When you get your bonus, tell yourself that you’re free to spend it, but only after you’ve left it in your savings account for a month. Keeping your bonus in your savings account will help you to reframe it as a part of your savings, which will make you more responsible when deciding what to do with it.
Or better still, precommit to saving 80-90% of whatever “free” money you get. When you get it, immediately transfer that percentage into a separate, untouchable savings account, and you’re free to spend the rest guilt-free (My ebook talks a lot more about this strategy).
2. Be wary of extras
Whenever you make a big purchase, break every deal into its component part. Would you ordinarily spend $6.50 for a soup and drink set on its own? If not, don’t tack on that extra when your waiter asks if you’d like to “complete your meal.” The same goes for insurance riders – that $20 a month may not seem like much when you compare it against a $2,400-a-year policy, but it buys just as much as $240 in your savings account – enough for a mini-getaway every year.
3. Schedule regular credit card checks
Credit cards are a little tricky – I love them because they offer great rewards and help me track my spending, but I know mental accounting makes me spend more on them. That’s why I set a hard limit on how much I can spend on them every month, and schedule reminders every two weeks to spend 5 minutes logging on to check my statements. When I hit my limit, I switch to cash.
Don’t feel bad about being susceptible to mental accounting because we all are (gee thanks, evolution). Instead, try to use the systems and mental frameworks I outlined above to get around it, and you might just find yourself a tiny bit richer – according to real accounting standards. 😉
This post is the first of my behavioral finance series – the psychological influences that affect our finances. I’ll be basing it off the book Why Smart People Make Dumb Money Mistakes by Gary Belsky and Thomas Gilovich – which is an awesome read even if you’re not a psychology nerd like I am.