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Afternoon brain snack: Mental Accounting

This week, I’ve decided to do a little series of “afternoon brain snacks” from the seven chapters of Why Smart People Make Big Money Mistakes and How to Correct Them: The Science of Behavioral Economics by Gary Belsky and Thomas Gilovich. Sort of a summary/commentary. This is Day 1, on the first chapter “Not All Dollars are Created Equal.”

Mental accounting is treating money as if it’s not equal. For example, we often feel more willing to spend “found money”–a gift or money that we somehow acquired without work on our part. On the other hand, we (hopefully) treat college funds as if they’re sacred.

The authors see mental accounting as both a potential pitfall and a useful tool.

US dollars all have the same buying power. If you wouldn’t take $50 from your savings account for this purchase, why do you spend your $50 of tax return money on it? (The authors point out, too, that tax returns are actually money you earned…like having a loan returned by a friend who didn’t pay interest.)

Their solutions? I’ll list them in order of my favorites, instead of using the book’s order.

  • Imagine that all income is earned income — Their key point, I think. Don’t treat money as if it’s unimportant because it was a gift or windfall. It’s still worth the same. Sure, you can use it to do something fun, but make sure you’re not just throwing it away.
  • Use mental accounting to your advantage — Don’t touch your IRA/401(k). Put your savings on automatic so that it doesn’t feel like you have as much money coming in. That way you’ll be less likely to find a place to spend it.
  • Hurry up and wait — If you get windfall money, wait on using it. 3-6 months if possible. Put it in your savings and see it make itself at home there. You probably won’t want to pull it out again, unless the purchase is really important to you.
  • See the trees for the forest — Don’t let lots of small charges build up into an amount so big that you don’t see it as charges any more. Otherwise you’ll be less hesitant to add to it.
  • Imagine a world without plastic — figure out what you’d be willing to pay/buy if you didn’t put it on your credit card. You can still charge it, they say, but be aware that this is real money, don’t stick it in the “big amount of money I’m going to pay off someday” file.

{ 2 comments… read them below or add one }

Laura October 22, 2007 at 2:42 pm

My professor mentioned this problem with us at the beginning of the class last year. Almost everyone in the class was willing to risk that money because ‘it wasn’t earned’. Money is money, use it wisely.

SavingDiva October 22, 2007 at 3:22 pm

Great post! I’m definitely guilty of blowing windfalls.

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