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.