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.

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.

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.

Successful Money Management is More About Psychology than Optimization

I don't really follow sports, so I got to this article a little bit late, but it illustrates a huge point about money management that I wanted to mention. Essentially, this basketball player (Michael Carter-Williams) created a trust fund for himself with the massive amount of money that he's earning from his basketball salary.

A trust fund is kind of a strange vehicle for someone to create for himself or herself. Usually they're used to transfer wealth between parties. In this case, it seems like he created a trust to prevent himself from doing something stupid and blowing all his money. By forcing himself into a sort of savings plan, he can avoid the pitfalls that many other pro athletes fall into.

I think that's brilliant.

Managing your money is about playing to your own strengths and doing things to compensate for your weaknesses. If you can't deal with seeing stock prices fluctuate, maybe you should invest in real estate or something else where you don't get constant price quotes. If you can't read a balance sheet and you don't want to think too much about your investments, then index funds are a beautiful thing. There are options for every disposition and temperament, you just have to know yourself well enough to choose the right thing.

Also, my brain exploded when I read this paragraph:

The lack of financial health is a major epidemic in pro sports, Dzamba said, with 60 percent of NBA players declaring bankruptcy within five years of their athletic retirement and some 78 percent in the NFL doing so, according to a Sports Illustrated report.

What!? There are no words for how ridiculous this is.