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.