Welcome to the DailyKobo article series on ‘Why Smart People Make Bad Financial Decisions’. In this series, we will be exploring some common financial decisions we make which aren’t in our best interest. But rather than discussing financial techniques, we will be focusing directly on behavioral issues, particularly the traps and psychological biases that even people who are good at high levels of reasoning and memorization (i.e. “smart” people) tend to fall into.
We strongly believe that identifying the psychological causes of our bad financial decisions would empower us to make the behavioral changes that are required to better manage the money we earn and effectively build wealth for the future.
TOPIC: 'ALL MONEY IS NOT EQUAL' - A BETTER WAY TO MANAGE YOUR INCOMING FUNDS
Have you ever wondered why people get lured by bargains into making needless purchases? Have you ever wondered why a person would drive across town to save $10 on a $20 purchase but won’t move an inch to save $10 on a $1000 purchase? Have you ever come out on top at a betting shop and instantly decided to treat yourself to something extravagant?
In theory, the situations above don’t make sense because every dollar should be treated the same as every other dollar regardless of its source or how we feel about it, a concept in finance known as the fungibility of money.
Fungibility, in a nutshell, means that $100 in lottery winnings, $100 in salary and $100 bonus should have the same significance and value to you since each $100 has the same purchasing power at the market. However, we don’t treat our money that way in practice, which then begs the question - why?
In 1999, behavioural economist R.Thaler attempted to answer this question by conducting a study on the psychology of choice. As part of his study, he asked his participants a set of hypothetical questions, the first of which was:
“Imagine that you have decided to see a movie and have paid $10 for the ticket. As you enter the cinema, you discover that you have lost the ticket.”
“Would you pay $10 for another ticket?”
In response to this question, only 46% of respondents said they would purchase another ticket.
He then asked the participants another hypothetical scenario:
“Imagine that you have decided to see a movie and, like the question before, a ticket cost $10. Only that this time, as you enter the cinema, you discover that you have lost a $10 bill.”
“Would you still pay $10 for a ticket to the movie?”
This time, a whopping 88% said they would pay for another ticket, and the reason why is quite simple.
Let’s say you bought a ticket in the first hypothetical and were asked how much the ticket cost, you are very likely to say $20 because you would have contributed a total of $20 to purchasing tickets and assigned $20 to the ticket ‘mental bucket’.
However, if you bought a ticket in the second hypothetical, you are likely to say the ticket only cost you $10 due to the fact that only $10 contributed to the purchase of the ticket. The other $10, which was lost, would not be allocated to the ticket ‘mental bucket’ but to some other mental bucket like ‘general spending’ or ‘unfortunate losses’. This human tendency to put money in different mental buckets is what Richard Thaler termed ‘Mental accounting’.
Mental accounting is the tendency for people to assign money to different categories, depending on where the money comes from and how they intend to use it. Mental accounting becomes a problem when we choose to categorize our money without looking at the bigger picture or considering our long term financial goals, which was the case with Janite Lee, the St Louis lottery winner.
Janite Lee was a wig shop owner in St. Louis when she won $18 million in the Illinois Lottery. Following her stroke of luck, she moved into a million-dollar house, leased luxury cars and went on a philanthropic spree - giving money to political candidates and the Democratic National Committee. She even snapped up a seat next to President Bill Clinton at a 1997 fundraising luncheon, according to the St. Louis Post-Dispatch.
But sadly 8 years later, Lee had filed for Chapter 7 bankruptcy protection with only $700 to her name and $2.5 million in debt [source: Carbone].
The unfortunate reason why Lee went bankrupt was because she didn’t treat her lottery winnings the same way she treated the money she earned while running her wig shop (only on a larger scale). Her lottery winnings were placed in new and exciting mental buckets like ‘luxury cars’ and ‘seats next to presidents’ which were, sadly, not in her long term best interest.
Another example of mental accounting is the difference between how people treat their end of year bonuses (thirteenth month payments) and their salaries. The thirteenth month payment usually involves you getting paid a full month’s salary as bonus at the end of the year.
What you’ll find in most cases, is that people don’t treat their bonuses the same way they treat their salaries, even though they are literally the same amount. Those bonuses tend to be allocated to more exciting mental buckets like travelling or shopping, which, if not done within reason, could lead to future regret.
So how do we gain control over how we allocate money into our ‘mental buckets’ to ensure that our income is optimized and our spending is always in line with our financial goals?
HOW TO OVERCOME
Firstly, let’s look at how we typically categorize our money in mental buckets. We tend to categorize our money using two subjective criteria:
1) The source of the money - money easily earned is not treated as carefully as our salary, for instance.
2) Our preferred mental buckets - This refers to where our interests lie. E.g. ‘travel’ money, ‘food’ money, ‘clothes’ money, ‘investment’ money, etc.
In order to optimize how we manage our income and overcome mental accounting, we would need to ensure all the money we get, regardless of its source, is put into mental buckets that contribute to our future financial goals before our preferred mental buckets.
In other words, we would have to ensure that a portion of ALL inflow of cash is directed towards our financial goals and obligations, before our preferred, more exciting, mental buckets come into play. Here’s a simple, easy-to-follow plan that i’ve devised to help you do just that:
Step 1: Outline your financial goal
This step is for those that don’t already have a financial goal in mind. Without a financial goal, it is impossible to structure your money; your spending will be circumstantial, depending on how you feel at a given point in time, and your money will likely be assigned to your preferred mental buckets without any real regard for your future needs.
Some common examples of financial goals are saving - to go for a trip, to buy a new car, to pay off your debt or to build an emergency fund. Its important that you have a financial goal in order to give your money direction.
Step 2: Calculate how much you want to save
Now that you have a financial goal in mind, the next step is to determine what percentage of your income you want to set aside consistently to meet your financial goal(s).
If you’re not sure of what to start with, I personally recommend 20%, based on the 50/30/20 rule which simply states that:
- 50% of your income should go to necessities like rent, bills and groceries.
- 30% of your income should go to non-essentials, things you want but don’t necessarily need like going out for dinner or watching a movie.
- 20% of your income should go to savings and debt, this includes emergency fund savings and any debt you owe.
The 50/30/20 rule provides a simple and clear strategy on how you can allocate money in your ‘financial goals’ bucket without having to constantly focus on penny-pinching.
You can start by saving as low as 10% of your income and then work your way up, the key here is for you to take action and use a saving percentage that you can follow consistently and build on.
Step 3: Pay yourself first
Now that you have decided on an amount to save, the next step is to pay yourself first. It is important to note that your ‘financial goal’ bucket and ‘financial obligation’ buckets must both be the first two areas of focus as soon as any inflow of cash occurs and not after spending has already begun.
“Whenever you get income, you must always pay your future self first” - Tweet this
Your savings (which is how your pay your future self) should be sent to a separate savings account to ensure that it is out of your focus. I also strongly advise that you automate this process at your bank by speaking to your bank officer about setting up a standing order between your current and savings account. This way you don’t even have to think about the process, out of sight, out of mind. Your lifestyle will adjust to the money you have left.
This brings us to the end of the 2nd article in our series of ‘Why Smart People Make Bad Financial Decisions’. I hope you’ve enjoyed it and learnt from it. Be on the look out for the next article!
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