Mental Accounting, Part 2 - Some Solutions

I've learned a blogging lesson from this post: don't promise what your next post is going to be about. I've been busy, but I kept putting off writing this post because I found other interesting things I wanted to write about. Basically what I'm saying is that I have the attention span of a caffeinated squirrel.

Last time I talked about mental accounting and the problems that come up with our brains and money. Now I'm going to talk about some solutions for shoddy mental math. The first "strategy" is to just be aware of the problem. Hopefully my last post helped with that. The rest of the strategies that I use basically center around re-framing in your mind how much things actually cost.

One-time purchases
For one-time purchases, I like to treat them as if they are yearly things. For instance, if I decide to buy a new rice-cooker, I probably won't need a new one next year, but I might need a new crock pot. By just assuming that I'll have to make similar purchases each year so that it evens out, it gives me a powerful tool to think about how much these things actually cost.

What I do is imagine how much I would need in investments to cover making this purchase once a year. The best research that currently exists suggests that withdrawing 4% of your portfolio each year offers very good odds of it not running out in a "typical" 30-year period. If you assume that the listed price of the item you want is only 4% of the needed investments, you would multiply the price by 25 to get the amount of investments needed to make that purchase yearly. In the case of my rice-cooker, If I buy a $30 rice cooker every year, I need $750 in investments to reliably cover that purchase every year. All of a sudden, I start to think that my current rice cooker can last for a while longer, instead of needing a fancy new $750 rice cooker.

Monthly Subscriptions
With monthly subscriptions (cell phones, gym memberships, etc.), we seem to love buying them, and companies love selling them. They are a great deal for companies because they offer a nice reliable revenue stream. However, most people would be better off paying a higher price only for the times they use these things than "saving" money buy subscribing. When we use a little mental math, you can see how expensive they get very quickly. Again I try to imagine them in terms of the investments that a person would need to fund them indefinitely. For a monthly expense, you take monthly price and times it by a whopping 300 (25*12) to get a number for investment income. That $30 gym membership? You need $9000 to fund that each year. Your $50 cell phone plan? You need $15000 to keep that each year. Now that stuff starts to look more expensive.

Purchases With Debt
Debt can get you into all sorts of trouble. I don't like using it. That deserves its own post, but let me just say that you need to be extremely careful when you're using debt. Companies that lend money tend to show you three important numbers: your monthly payment, the interest rate, and the total amount of money that they'll lend you. Most people take on debt thinking about how much the monthly payment will be. Based on the number of bankruptcies and credit defaults in this country, this thinking gets people into trouble. Let me suggest a fourth number that you should look at: total payoff amount. You might need an online calculator like this one, but a few minutes with that can save you lots of money. I put in a hypothetical car loan of $10000, with a 5% interest rate and a minimum payment of $195. The total amount of interest paid was $1256, meaning that you payed in total $11256 for that car. Just by saving your money and paying in cash you essentially pocket an extra $1250.

There are lots of other strategies, but these are some of my favorites. The particular strategies that you use don't matter so much. What is important is that you find some mental tricks that work for you to curb your ridiculous spending impulses. (Don't feel too bad though, we all have them.)

Mental Accounting Part 1 - The Problem

Has anyone ever noticed that brains look a bit like intestines in drawing like this? I guess folding is efficient no matter where it occurs.

As human beings, we're subject to the limitations of the brain. While our minds are amazing and wonderful tools, they also have a tendency to get tripped up and bogged down when presented with particular situations. However, if we can understand some of what makes our minds tick, we can create situations where our brains will perform to the best advantage, while minimizing the times where our impulses get us into trouble. Psychologically, you could call these tendencies "mental models," and while there is some debate about whether that's how the brain actually works, the concept offers a useful approach to counteracting some of our innate weaknesses.

Many of these mental models affect how we deal with money. I was listening to the Freakonomics podcast this morning and they were discussing a potentially dangerous-to-your-wealth mental model called "mental accounting." Here's what happens: people tend to treat money differently depending on the form that it's in. For instance, if you're at a diner and a soda is two dollars, most people would likely be okay paying that if it was with a credit or debit card. On the other hand, if you've only got ten dollars in cash to buy lunch, many people would skip the drink and just have water. The amount that it costs you is the same in both cases, but because the method of payment is different, people treat the money differently.

A similar mindset afflicts most of us when we see something for sale. We look at how much we're "saving" and forget the fact that in order to buy something we have to spend money. We also tend to buy things by looking at how much the monthly payment is, and not how much money in total the actual item is going to cost. Not all of these would strictly be called "mental accounting" to a psychologist or an economist, but they all represent ways in which our skewed perceptions of price, value, and money can potentially cause us problems.

So what to do about it? Next post I'll talk about some strategies to help out our silly brains.

OFtM Principle #3

Guess what's inside! You're going to love it.

One for the Money returns today for principle #3: Learn self-discipline and self-restraint in money matters. There are tons of quotes in here that are worth your time. Let's start with, "Young couples should recognize that they cannot immediately maintain the same spending patterns and life-style as that to which they were accustomed as part of their parents’ family."¹ Every young married couple needs to hear this over and over again until it sinks in. I should start giving framed versions of this as gifts at weddings. It would make me really popular.

I feel very strongly about this quote because I see it ignored so often. People who are still in college buy big screen tvs with their student loan refunds. If you have to buy a tv with money that you borrowed, then you can't afford it. In fact, if you have to buy any depreciating asset (more on this term in another post) on credit then you can't afford it. Consumer debt is bad. That statement needs no qualification.

Young couples (and singles for that matter) need to embrace being poor for a while. There are tons of options for getting what you need for cheap. Thrift stores have much better clothes than they once did. You can get nice things that are essentially new for a huge markdown. Online sources like craigslist and freecycle offer more ways to get things that you need (and even things you just want) for a reasonable price. The tradeoff is that you have to spend time finding good deals. But when you're poor, time is much easier to come by than money. Use your time to save yourself some money.

In our "self-indulgent, me-oriented, materialistic society,"² we ought to be a group of people who stand out as being different. Let me tell you a secret: stuff doesn't make you any happier. It's a poor substitute for happiness. Helping others makes you happier. Living within your means makes you happier. Gratitude makes you happier. "Gratitude is a Spirit-filled principle. It opens our minds to a universe permeated with the richness of a living God. Through it, we become spiritually aware of the wonder of the smallest things, which gladden our hearts with their messages of God’s love."³ Rather than striving to buy on credit the largest things we can, perhaps we should strive to be grateful for all of the small blessings in our lives. There's no glamour or happiness in paying off consumer debt, only pain and misery. However, a grateful attitude will pay dividends for years after that big screen has stopped working.

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1 "One for the Money" pamphlet, pg. 6^↩
2 Ibid^↩
3 Bonnie D. Parkin "Gratitude: A Path to Happiness" April 2007 General Conference^↩

I Try to Avoid Silly Consumerist Things, but I Still Have my own Kryptonite

I was thinking the other day about how easy it is to get sucked in by the marketing that we see thrown at us. As far as I'm concerned, the typical "American Middle Class Lifestyle" is built on top of a mountain of waste and cheap junk. I don't really watch network tv (Netflix is basically all you "need"), and I don't have cable. I try not to allow the marketing machine to have a lot of access to my brain, because a lot of people who are smarter than me have bet a lot of money that I'll buy their junk if they show it to me enough times. If you don't think commercials and marketing have an effect on you, you're fooling yourself.

There is one silly consumerist thing that I still love though: "The Price is Right." I know it's basically just a thinly veiled ad for a bunch of companies. And I know that winning is mostly luck and not skill. I know that the prizes are mostly ridiculous and wasteful. I know that people probably pay obscene taxes on anything they win, so it's not even that great anyway. But regardless of all that, I totally love the show. Score a point for the evil consumerist marketing machine.

The First $100,000 is a Benford

Image taken from Wikipedia, thus the labeling in a foreign language...

Warning: This post uses math. If that is a problem for you, just skip this one. No hard feelings.

Charlie Munger famously said "the first $100,000 is a [naughty word that starts with B]." With apologies to Mr. Benford for conflating his name in an unfavorable way, there's a perfectly good mathematical reason why things work this way: Benford's Law.

Benford's Law basically states that if you take a large group of numbers spanning several orders of magnitude, the probably that any number will begin with a one is close to 33%. If this seems counterintuitive, here is a video explaining it in more detail. It's nine minutes long, which is an eternity in internet time, but I found it fascinating.

Near the end of the video, the guy mentions stocks as an example of Benford's Law. Let me instead use your net worth. Every time you add another digit onto your net worth, you'll be stuck near that number for a while. Think of it in terms of doubling your money. Imagine that it takes five years (I wish) to double your money. You start with $10,000. To get that first $100,000, it will take you something like seventeen years. Then to get your next $100,000 it would only take five years. Then less and less as your money picks up momentum. However, to go from $100,000 to $1,000,000 would take seventeen years again.

So what do we do with this information? Well, first, start saving and investing early, so you have many years of compounding ahead of you. Second, don't get discouraged with small efforts. Money attracts more money. As your investments get larger and larger, they'll earn more and more money on their own without any work from you. "Now ye may suppose that this is foolishness in me; but behold I say unto you, that by small and simple things are great things brought to pass; and small means in many instances doth confound the wise."1

Just remember, there's mathematical proof that the first $100,000 is, in fact, a Benford.

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1 Alma 37:6^↩

A Tale of Two Dinners

The three biggest expenses for the majority of Americans are food, housing, and transportation. If you can get your spending under control in those areas then you'll have a much easier time in general. They're what you might call "big wins." I'll talk about the latter two in another post, but I wanted to talk about food a little bit.

One typical piece of advice that people get is to stop eating out and cook your meals at home. I agree with this advice as far as it goes, but what are you supposed to cook? I was at the store the other day buying groceries for a couple of meals, and I was struck by the differences in price. Here are links to the recipes:

Thai Shrimp and Noodles

Potato Leek Soup

Both of these meals will be cooked at home, but the amount I pay per serving is hugely different. Take a look at the approximate¹ ingredient cost for the Thai dish:

1 pound cooked medium shrimp, peeled and deveined - $10.00
1/3 cup Italian salad dressing - $0.33
8 ounces uncooked angel hair pasta - $0.50
1/4 cup chicken broth - $0.10
2 tablespoons minced fresh cilantro - $0.15
2 tablespoons chunky peanut butter - $0.13
1 tablespoon honey - $0.17
1 tablespoon soy sauce - $0.17
1 teaspoon minced fresh gingerroot - $0.25
1/2 teaspoon crushed red pepper flakes - $0.03
1 cup julienned carrots - $0.35
1 cup chopped green onions $0.65
2 tablespoons canola oil - $0.06
1 tablespoon sesame oil - $0.35

Total Ingredient Cost: $13.24
Cost Per Serving: $2.21

I consider this meal to be extremely expensive compared to a normal meal at home, but most of that is the shrimp. Even so, this meal costs about the same amount to make as it would cost my family to eat at Wendy's (if we're eating off the dollar menu). If you made this kind of meal every night, you would spend nearly $400 per month on dinners alone. Adding in the other two meals and snacks and you've got a food budget that is out of control.

Now compare that to the Potato Leek Soup.

2 tablespoons neutral oil, such as canola or grapeseed oil - $0.06
4-5 medium russet potatoes (1 pound), peeled and roughly chopped - $0.65
3 large leeks (1 pound), cleaned, and thinly sliced - $3.00
6 cups vegetable stock (or light chicken stock) - $4.60 (or basically $0.10 if you use water)Kosher salt, to taste (I consider salt and pepper to be basically free when figuring out recipes since they're so common and usually not measured in specific amounts)
1-2 tablespoons freshly squeezed lemon juice - $0.07
1/2 cup heavy cream $0.62 or 1/2 cup crème fraiche (I just use 1 cup of heavy cream, but the price would be similar) $0.62
1/3 cup minced parsley or chives - $0.35

Total Ingredient Cost: $9.97

You're starting to save money with this, but as I mentioned above, I would probably use water instead of vegetable stock, and maybe add a little celery or something. With those changes, the price would look more like this:

Total Ingredient Cost: $5.72
Cost Per Serving: $0.95

Look at that. Less than a dollar per serving to feed people a nice dinner. If you eat like this every night, then you would only spend $171 per month on dinners. This dish isn't even the cheapest one you can make. Just by changing your meal planning a bit you can find over $200 per month that you can use to pay off debt, invest, or take a vacation. So while the general advice of "eat at home" is good advice and will generally save you money, even within that framework there are lots of options for optimizing your life and saving you money.

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1 The prices are a mix of what I payed on the receipt and what random prices I could find with a quick internet search. The actual prices you would pay might vary quite a bit. I'm sure a dedicated coupon clipper could get both meals for cheaper, but the relationship between the two would be similar.^↩

Teaching Kids About Money

My parents were basically fantastic. I'm going to indulge in a little bragging right now, so forgive me. They have a good strong marriage, they taught all of us about the Gospel, school, work, happiness, marriage, and getting along with others. Basically they covered most of the major topics that a person needs to know to have a happy and fulfilled life. I've heard them say that one of their major goals was to create self-sufficient and well-rounded children who could do well in the world. While that's probably a goal for most parents, mine worked and planned to teach us the things that we'd need. More than just a nice platitude, that goal informed the way they approached parenting. Basically, when my wife and I are unsure about what to do with our kids, we'll try to figure out what my parents would do.

As great as they were, finances are one area that my parents could have covered better in their various life lessons. I don't think they fully understand money themselves though. They hit many of the most important things like "spend less than you earn," and "save up for things you want instead of buying them on credit," but they didn't really do much to explain other concepts like investing, savings rates, asset allocation, etc. I didn't really start to understand how investments worked until I researched it on my own.

My wife and I have been pondering how to teach my kids more about money than I learned. They're pretty young, so we have some time to figure things out. but we have done one thing: we established a custodial account for each of them.

A custodial account is a special kind of brokerage account. Basically you can buy stocks just like you would with a regular account, but the stocks are owned by the child whose name is one the account. You (the parent) act as the custodian and have full control until the child reaches a certain age. In most states the age is twenty-one, while a few are as low as eighteen.

I am a firm believer that kids learn best by doing. In this case, I want to have a real account statement that I can show them. I'm hopeful that it will be a useful tool for the kids to learn about money and math. For instance, when you're learning addition and subtraction, how much more interesting would it be to be able to use real numbers and see how much money you made or lost in a year? What about when they're learning about compounding interest? Suddenly they can see a real example of compounding interest before their eyes. I can imagine them using data points to create plots when they learn about graphs. Basically I want this to be something that they can be involved in and see grow.

A custodial account lets them own real securities in companies that they like. While I typically consider index funds to be the best investments for most people, for a kid to own a few shares of Disney, General Mills, Mattel, Nintendo, or Coca-cola could be something really exciting and could tie all this financial stuff to the real world.

I have high hopes for these accounts as learning tools, but there are a few drawbacks to be aware of if you're suddenly considering starting these up for your kids. First, it's possible that your kid might be an idiot when they're eighteen or twenty-one. I know I was. For me, it would frustrate me if they wasted this money, but at some point you have to let them make their own mistakes. I would consider that I had done my best to teach them, so if they mess it up there's nothing I can do about that.

Second, they aren't great vehicles for transferring a lot of wealth. I'm looking at probably less than $15,000 when all is said and done. If you've got a much larger amount of money to transfer to a child, you'll be better off with a trust fund.

Third, if one child's investments do better than the other's there could be some jealousy. This could be a problem or an opportunity. I'm hopeful that my kids will learn to be happy for each other, not to compare themselves negatively with each other, though that might be a bit of wishful thinking. We'll cross that bridge when we get there.

Finally, the money is actually the child's as soon as it goes in the account. There are serious issues with parents having some buyer's remorse and wanting their money back. You can't do that. In the eyes of the law, it's robbing from the child. Technically you could probably get around most legal issues if you raided the account, but it's wrong to do so. We believe in "obeying, honoring, and sustaining the law," right? Don't put money in there that you're going to need back in the future.

As for me, I'm excited with the possibilities that come with the custodial accounts. I think there are tremendous opportunities for teaching my kids and I'm excited to see what happens with these accounts.

If you're interested in opening a custodial account, there are lots of options. I chose sharebuilder.com since we already do our banking with capitalone.com, but do what works for you.

Happiness Comes from Sticking to Your Principles

I was browsing the forums at one of my favorite money sites and I ran across this post, which I've been thinking about quite a bit. The ten percent tithing payment in the budget caught my eye. I don't know if he's Mormon or not, but the reader who submitted the post at least has a similar set of values.

The reason that I've been thinking about the post is that several commenters suggested that he reduce or eliminate his tithing payments. A favorite argument of this crowd is that you don't pay while you're young, and then when you're a little older and more financially secure you can give ten percent or even more to the church. God wouldn't want you to put your family in danger or struggle financially because paying tithing is hard, right?

Here's the problem I have with that philosophy: money is just a tool. It's pretty good for buying a blender or something like that. It's excellent for buying time and freedom, but it's garbage at buying self-respect and principles. More money can increase your happiness and satisfaction to a point, but if you compromise your beliefs in order to get there, then you'll lose more than you gain every time.

How many of us still remember stupid things we did wrong from long ago? A test you cheated on, a lie you told, a small item you stole, a friend you betrayed... Those things stay with you.

I will freely admit that I love talking about money and I love the way it works. I hope every dollar I get acts like a polygamist and makes a whole lot more dollars. But I refuse to compromise on things that I believe God has commanded me to do. So if anyone ever asks for my advice with a budget, I will put tithing right at the top, where it belongs.

OftM Principle #2

One guy is you, one is your money. You pick which is which.

Returning to my "One for the Money" discussion, it's time to look at the second principle that Elder Ashton gives: "Learn to Manage Money Before it Manages You."

One of the greatest travesties perpetrated by our modern educational system is that lack of formalized instruction on money management. The reality of life is that you need to take responsibility for your own education in this subject. I see stories all the time of people with decent salaries who live beyond their means and end up ruining their lives. I also see stories of people making their budgets work no matter how much they are making.

I've mentioned the Micawber principle before, but it bears repeating. You're happiness will be heavily influenced by how well you manage your money.

There's a fantastic line in the second paragraph that I think people overlook. "New attitudes and relationships toward money should be developed constantly by all couples." Preach brother. I can't stress this enough. My wife and I deal with money differently than we did last year or even six months ago. Your relationship with money must change constantly based on your income, your goals, and the broader economy. Most people respond far too quickly to an increase in income with an even greater increase in lifestyle. Conversely, most people are far too slow at reducing their lifestyle when faced with a reduction in income. Don't be that person. You and I can do better. We can be better at this than the average person.

Once again the pamphlet is spot on with its advice. Money should be a tool, not a taskmaster.