Tuesday, April 22, 2014

Baseline Personal Finance Rule #1 vs. Mental Accounting

Baseline Personal Finance Rule #1, as invented by me on the spot in an earlier post, is:

“Spend no more than you need to on the things you've chosen to acquire or do.”

Rule #2, “Choose wisely what to spend money on, especially when it’s recurring” might seem like it should come first, but Rule #1 gets its spot not necessarily from its relative importance or any conceptual primacy, but from the fact that it’s the one that comes to mind more often.  That is, it’s the one I have to remind myself of more often, and make an effort to apply to my actions.  Rule #2 is certainly important, but I think in practice it’s a little more obvious and a little easier to live with, so it takes up less mental space.

So back to the matter at hand: today I want to talk about one of the ways that I’m always trying to break Rule #1: mental accounting. *

One way of describing what the term means: mentally assigning amounts of money to different categories based on origin or purpose and applying a different utility function to each category.  A simpler way of saying the same thing: if you find yourself telling a story about where a particular chunk of money came from, you’re engaged in mental accounting.  The term comes from behavioral economics (I’m told that it was coined in 1980), but of course the practice has been around forever.  (It’s one of the defining traits of Richard Carstone in Dickens’s Bleak House that every time he avoids spending money on something, he views the amount not spent as a windfall and starts looking for something else to blow it on.)

Now is a good time to be talking about this, because people who waited until the deadline to file taxes are about to see their refunds come in.  Tax refunds are a classic mental accounting scenario—since it comes all at once and from the government (rather than from an employer, where “regular” money comes from), people ask the question “What should we do with...” or even “How should we spend…” their refund, and come up with answers that would never fly if the money were coming out of a savings account.

I’m glad to say that one doesn’t get me.  At least not anymore.  But I do find myself fighting the mental accounting impulse, especially by looking at money that comes from irregular sources or can be construed as a windfall as “cheaper money” that I can justify putting towards things I wouldn’t spend regular, full-value money on.

One that comes up a fair amount is credit card rewards.  Since I returned to playing the sign-up bonus game a couple years ago, I occasionally have $100-$400 coming in from a one-time source, and which I did almost nothing to acquire.  It’s hard not to categorize that as “windfall” and let it go way more easily than I normally would.  Even worse is when it comes in the form of gift cards—there are several stores that I know I’ll eventually spend money at, so I’ll take rewards in the form of gift cards (or occasionally buy discounted gift cards directly) and consider them almost as good as cash.  But it still takes a lot of discipline to not let the “Well, I have a gift card” idea influence my purchasing decisions.

But Rule #1 helps.  Focusing on “spend no more than you need to” recategorizes money into the part that has to be spent to meet the need and the part that doesn’t.  Regardless of where it came from, clearly that second part is money that I should hold on to.

* Note: this is the first in what I hope will be a series, with the next two being “vs. Anchoring” and “vs. Just Plain Laziness”.

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