We often spend money out of our habits and instincts. But do we really know how to properly judge the value of what we are buying?
In Dollars and Sense, author and behavioural economist Dan Ariely explores some of the most common mistakes people make when dealing with money. By understanding the psychological factors and our cognitive constraints, it would help us make better money choices.
Some of the questions answered are: “Why are we willing to spend more on the same item when on a holiday than at home? Why do we overspend when using a credit card than when paying with cash? How can we properly assess if the things we are buying are actually worth it?”.
Many personal finance books overemphasise on budgeting – how to budget, why we should budget etc. But this book uncovers the psychological biases we have about money, to help us in making good financial decisions.
A personal finance book dotted with humour makes it an enjoyable read. Here are 3 key insights from “Dollars and Sense – How We Misthink Money and How to Spend Smarter”:
Be Aware of Mental Accounting Shortcuts
We are naturally bad at budgeting and managing money. As humans, we have cognitive limitations and are influenced by emotions.
Often, we tend to take “mental shortcuts” (heuristics) in order to justify our spending. We categorise expenses ambiguously and to different mental accounts.
What is Mental Accounting? Coined by a behavioural economist, Richard Thaler:
Mental accounting is about how we treat money differently, depending on the source of the money and it’s intended use.
In our personal lives, generally, we set a budget for food, clothes and entertainment, bills and investment etc.
But the problem lies in this – we are not strict with the boundaries. We manipulate and creativity assign expenses to different mental accounts, in order to trick ourselves for overspending on a certain category. This is known as malleable mental accounting.
For instance, maybe we shifted the meal from the “food” to the “entertainment” account in order to make dinner work.
Another example would be to combine purchases, by lumping the small expense under a larger category. That way, we can fool ourselves into believing that we are suffering just one big purchase. Instead of incurring two losses, which is more psychologically painful.
Buying furniture for the house? Instead of having 2 separate budget accounts, we frame it under one account – “Housing and Furniture”.
In this way, we would feel “less” pain for buying excessive furniture items. Plus, we would think that the furniture is part of the house when we move in. Combining purchases makes us spend easily and without much thinking.
Another hidden factor influencing our mental accounting is emotions.
We sort our money into different accounts, with different spending rules, depending on how it makes us feel.
For instance, when you receive an iTunes gift card, you spend it as though it is free money. You would buy things you normally would not purchase compared to if the money was spent using your salary.
“People are likely to spend something like their salary on “responsible” things like paying bills, because it feels like “serious money.” On the other hand, money that feels fun—like $300 million in casino winnings—is likely to be spent on fun things, like more gambling.”
Let this sink in: Even though all dollars are equal, we spend money based on how it makes us feel.
If we worked hard for the money (teach tuition to earn $50/hour), compared to receiving angbao allowance or mahjong winnings (gain $50 in 1 hour), we would likely treat the money differently. We would factor in the hard work, time and effort we’ve put in to get that money.
Although they are both $50, which logically should be equal, they are valued differently – the hard-earned money is harder to let go. And we would likely spend it on more important and practical items.
However, it is not to say that having mental accounts is a bad thing.
While mental accounting is not a rational approach to money, it can be useful if used judiciously. Mental accounting is useful if you are disciplined to follow through the rules that you have set. Budget categories can be helpful in controlling our spending.
Key Learning Points: Beware of mental accounting shortcuts (e.g. categorisation, combining purchase, emotional accounting). We are our own auditors, create our own rules, but without any whistleblowers.
The next two key insights illustrate how you can improve at making money choices:
Think About the Opportunity Cost in the Same Category
As humans, we suffer from opportunity cost neglect. In other words, we fail to see the next best alternative. We tend to focus only on what is obvious at the moment, ignoring relevant information (e.g. alternatives) which might not be explicit and in our face.
When spending, a rational consumer would always think in terms of a trade-off. “If I were to purchase this now, what am I giving up on now or in future?”.
But thinking this way is simply too hard and abstract. And we tend to simplify things and take mental shortcuts instead.
Apart from categorising and combining purchases, another mental shortcut we take in our “mental accounting” is to compare. Why do we compare?
- We make comparisons especially when we can’t assess the absolute value of things.
- Price is an easy way of comparing two items. It is easy to quantify and measurable, compared to comparing product quality.
For instance, when we see a sale, we spend less time considering the quality of the product and other options. Rather than trying to figure out the product’s absolute value, we take the path of relatively least resistance, which is to compare the price.
With the rise of online shopping, we are constantly exposed to discounts and flash sales from Shopee and Lazada. As we watch the countdown timer ticking towards the end of the sale and the limited stocks left, it triggers our FOMO (fear of missing out).
“Save 40% when you check out now!” “Lowest priced guaranteed!”
We think, “If I don’t act fast and act now, I will miss out on this good deal”. Often, this leaves us grabbing coupons we don’t need and purchasing items impulsively.
Discounts dumbfound our decision-making process. It gives us tunnel vision and we narrowly focus on the price difference, rather than on other product qualities, while continuing to ignore opportunity costs.
Don’t be pressured to purchase something (which you might not even need), just because it was on a discount.
“Free is a price. It’s a price that disproportionately grabs our attention.”
How Should We Think About Opportunity costs?
Opportunity costs are alternatives. The things we sacrifice in order to do something now. Each time we buy something, we are forgoing the chance to purchase something else using that same amount of money.
Given our computational limitations, it is far too complex to think about all the endless types of things we could have bought. Thus, we have to think about then the next best alternative in the same category.
For instance, every time we buy Starbucks coffee for $8, we can’t reasonably think “Oh, I could have used this money for my Netflix subscription, to buy new clothes, or the infinite other types of purchases now or in future.”
Instead, we can use mental accounting to help us, and consider that coffee as part of our “Food” account. “Oh, this could be half my lunch today or an extra coffee tomorrow.”
From this perspective, mental accounting (e.g. categorisation) is still not rational, but it becomes a sensible and useful tool, especially with our limited cognitive capacity.
Key Learning Points: Sales gimmicks and discounted prices confound us. We need to think about the opportunity cost in the same category to make smarter money decisions.
On Self-control & Building Systems
Often, we fall prey into spending on our wants and not our needs. Some might also be guilty of purchasing things on impulse, only to regret it later.
Thus, it is more important to always have clarity on our goals in life. This prevents us from steering away from our goals and to spend money unnecessarily.
As mentioned by James Clear in Atomic Habits, focus on systems, not goals. For example:
Goal: To save up for the next holiday trip or a big-ticket item (e.g. car or house).
System: Set up a separate savings account and make it the “untouchable” account.
Another system which I personally use is a money tracker app (check out this one by Seedly). Whenever I make a purchase, I will manually record my expenses on the app. This helps me keep track of exactly where my money went.
At the end of every month, I would import all my expenses to an excel sheet. Thereafter, using a pivot table, I would analyse my spending for each category and ensure that I am spending within my limit.
For each month, I would preset a limit for spending on each category (e.g. $50 on shopping). If I were to overspend on a certain month (say, exceed by $10 on shopping), the balance will roll over to the next month (i.e. can only spend $40 maximum).
Though the whole process might sound complicated and time-consuming, it is actually not. In fact, it takes nothing more than 30 minutes every month. Tracking my expenses this way has become a habit for me. Find a system which works for you and stick to it diligently.
Key Learning Points: Once you gain clarity on your goals in life, you’re better able to prioritise the use of your money. Build systems, not goals and improve your self-control.
The next time you are making a financial decision, or when you feel lured into the temptation of spending unnecessarily, remember these 3 key pointers:
- Be aware of your own mental accounting shortcuts
- Weigh the opportunity cost – What are you giving up when you purchase this now?
- Have self-control. Build systems to achieve your long-term plans
Leaving you with a quote from Warren Buffett:
“If you buy things you do not need, soon you will have to sell things you need.”
Warren Buffett
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