Imagine a person who always
makes the right financial decisions.
Let's call her
"Penny."
Penny approaches every money
problem with perfect logic and reason.
She never gets emotional
or impulsive
and always knows
what's in her own best interests.
You're probably thinking that Penny sounds
imaginary (and kind of obnoxious).
But for over
a hundred years,
most economists believed that
the world was made up entirely of Pennys.
That you and I
and everyone you know
always made the best decisions
to maximize our happiness.
As crazy as that sounds,
that was the conventional wisdom...
until a small group of economists
and psychologists
started to question whether
Penny actually existed at all.
One of them, Richard Thaler,
won the Nobel Prize last year
for showing that not only
do humans make financial mistakes,
they make
predictable mistakes.
He joked about calling his research
"Dumb Stuff People Do,"
but today it's called
"Behavioral Economics",
and it has changed public
policy across the world.
Thaler showed that humans can't
quite remove their emotions
from the decision-making
process,
but being able to predict these money
mistakes might help YOU avoid them.
Let's say you're helping
your mom clean out the garage
and you find a pack of
Pokémon cards
that you must've bought when
you were a kid and forgot to open.
So you go through them
and HOLY COW
there's a first edition
Charizard in mint condition!
Even though you could easily
get $3,000 on eBay for it,
you decide to buy a frame
and keep it on a shelf in your apartment.
Okay, let's rewind and consider
a different scenario:
Instead of helping your mom
clean out the garage,
you decide to go to the comic
book store.
There in a glass case you see a first
edition Charizard card priced at $3,000.
Even though you
used to love Pokémon,
you would never dream of
shelling out that kind of dough
for a playing card,
and you leave the store.
This may seem like understandable
behavior, but it's completely irrational.
In the first
scenario,
you're deciding that a Charizard
card is worth giving up $3,000 for,
but in the second
scenario,
you're deciding a Charizard card
is not worth giving up $3,000 for.
To a perfectly rational
being like Penny,
whether or not
you already own the card
should be irrelevant
when judging its value,
but clearly to humans
like you and me, it's very relevant.
Thaler called this
the "endowment effect,"
our tendency to assign more value
to the things we already own
than the things
we could own.
Any time you refuse to sell
something for an amount
that's more than
you'd pay for it,
you are experiencing
the endowment effect.
Ugh, this movie is awful!
I know.
Why don't we watch something else?
We can't.
Why not?
I paid 6 bucks to rent this movie!
We can't just throw that money away!
Ugh!
You burned the popcorn!
We have to finish it.
That bag cost us 89¢.
Have you ever watched a movie
you hated all the way to the end
or finished a meal
you weren't enjoying,
just because you paid for it and
you wanted to get "your money's worth"?
If so, you have fallen victim
to the SUNK COST FALLACY.
It's not like sitting through
the Emoji Movie
will magically refund
the rental price -
that money is sunk,
and it's not coming back,
so why put yourself
through the extra pain?
Most of us keep an emotional
balance sheet in our head,
which is less concerned with
actual gains and losses
than the feeling
of gains and losses.
Even though watching
the movie makes you less happy,
at least if you sit through it
you don't have to count that $6
as a loss in your
mental checkbook.
Our fear of
sunk costs is so great
that businesses can use it
to squeeze even more money out of us.
Many retailers sell
"memberships"
that include perks like
discounts and free shipping.
They know that some
people will buy extra stuff
they don't
really need,
just to make sure they get
"their money's worth".
Imagine that you're shopping
for some headphones
and you're about
to buy some for $15,
when you find out that
the store down the street
is selling the exact
same pair for $10.
It's just
a ten-minute walk.
Would you do it?
Now, same scenario, but this
time you're shopping for a laptop.
The first store has the model
you want for $675.
The second store $670.
Now do you take the walk?
Many people will answer
these two questions differently,
even though they are
essentially the same question:
Is it worth $5 to take
a 10-minute walk?
All other context
should be irrelevant.
Yet people are more likely
to say yes to the first scenario,
because it feels like
you're getting a better deal.
This is called
transaction utility,
the amount of mental
pleasure or pain
we get from feeling like we paid less
or more than something's really worth,
and it's often totally
disconnected
from the happiness
you get from the thing itself.
Stores have been exploiting transaction
utility from time immemorial,
like the notoriously inflated
"manufacturer's suggested retail price,"
which makes it look like
every item is always on sale.
And some shoppers are
so addicted to transaction utility
that they'll fill their houses
with stuff they don't need
and will never use
just to chase that bargain high.
Of course, it's always important
to shop around and find the best deal,
but remember that when
considering any purchase,
the only thing that matters
is what it's worth to you.
If you won $100 on a lottery scratcher,
what would you do with the money?
Buy an expensive pair of shoes?
Go out for a fancy dinner?
Most people say that they're more
likely to spend unexpected income
on something indulgent
or frivolous,
because hey, it's not like
I worked for that money.
It was free!
Thaler called this kind of thinking
mental accounting,
which means separating money
into imaginary categories in your mind.
Mental accounting violates
the rule that money is fungible
- that is, totally
interchangeable.
Once you own a dollar,
it's the same as any other
and it shouldn't be treated differently
just because of where it came from.
For Penny, that pair of shoes is either
worth giving up $100 for, or it's not.
Just because some money
unexpectedly showed up
doesn't make
the shoes worth more.
Mental accounting can be helpful in making
monthly budgets and sticking to them,
but even then it can lead us
down irrational roads.
One study focused on how
consumers reacted to a drop in gas prices
from 4 to 2 dollars a gallon.
This was at the beginning of
the 2008 financial crisis,
so you'd think that most families
would've had a lot of use
for that extra
40 bucks a week.
Instead, researchers found that
people were surprisingly likely
to squander those savings
on a higher grade of gas!
It's as if
in their minds
they had budgeted
a certain amount to gas,
so it had to be
spent on gas.
They couldn't treat
the money as fungible.
Mental accounting exists for
the same reason a lot of fallacies do:
because our brains
aren't perfect supercomputers
and we use a lot of mental shortcuts
and emotional instincts just to get by.
But knowing what
those shortcuts are
will make you less likely
to rely on them in the future.
You may not ever be as wise as Penny…
but being pennywise is pretty good, too.
And that's our two cents!
If you want to hear more
examples of "dumb stuff people do,"
check out Richard Thaler's Misbehaving:
The Making of Behavioral Economics.
It's a funny and fascinating
history of Thaler's research,
full of surprising studies
that will inspire you
to think differently
about money.