If you happen to have cash in your wallet right now, take out a note and have a look at it. It’s just a piece of paper. It has a picture of someone famous on it, a few words and a number. That’s what money is.
In real terms, it is a medium of exchange created because bartering got a bit tricky, e.g. how do you value your cow when you want to swop it for a sack of grain. But, as you will see, not all dollars are equal!
Sounds all very rational doesn’t it and it kept the economists happy. But the economists forgot a very important point. We aren’t rational! So, when we see the piece of paper with pictures and numbers on it, we see a lot more than a symbol to buy stuff. We see all sorts of emotions and meanings and it’s different for men & women.
Here are a few of the ways that we look at money and see more than just face value.
We find it easier to make spending decisions if we allocate money to mental ‘buckets’ that are designated for particular uses. We might have a bucket for food, rent, savings, for example. We don’t like to spend our rent money on a night out and if we dip into our holiday savings for ‘that’ pair of shoes, we can get decidedly testy.
We value money differently depending on its source. We will spend the $50 birthday money with less thought than $50 we earn from our work. This leads to a problem and causes us to spend too quickly, save too slowly or be too conservative when we invest.
How do you challenge yourself and your mental accounting system? Ask yourself, if this was my salary would I choose to spend it on this?
Also known as ‘throwing good money after bad’. We make decisions based on how much we have already spent. We don’t just do this with money. We will sit through a really bad movie because we have already watched half of it.
Why are Sunk Costs so powerful that we keep spending on a project even though deep down we know it isn’t going to recoup what we have spent?
Because we view the money we have spent as a loss.
For example: If we walk away now, we’ll lose what we’ve spent – conveniently ignoring we may make a larger loss if we continue.
How you do recognise that the Sunk Cost Fallacy has you caught? You make important spending decisions based on how much you have already spent.
If this is you, then stop and make a serious review of what the future expenditure and then decide on whether or not to proceed. Have someone look over your shoulder who isn’t emotionally involved in the project.
We can also get confused between Sunk Cost and Opportunity Cost. Here is a story from Richard Thaler.
You purchase a bottle of wine for $50 and pop it away in your wine cellar. How much does it cost you to drink that bottle of wine 10 years later when it is now worth $500?
Your Sunk Cost is $50, the original investment, so your mental accounting would say it doesn’t cost you anything to drink it 10 years later.
Opportunity Cost however, says the cost of drinking the wine 10 years later is $500. Opportunity Cost is what you give up by doing something now. You could sell the wine for $500 and do something else with the money.
If you want to be totally rational you will sell the wine and use the money for something else…. I know which I would do!
The loss Aversion theory says that ‘people feel more strongly about the pain that comes with loss than they do about the pleasure that comes with an equal gain’ (Why Smart People make money mistakes. Belsky & Gilovich).
We feel a financial loss twice as strongly as we do a financial gain.
Loss Aversion is commonly talked about in the investing world. This is what causes investors to pull their money out on a downward cycle rather than riding it out. It is also why gamblers place larger bets when they are on a losing streak, they are willing to take bigger risks to recoup losses.
Loss Aversion can also lead you to make financial choices that aren’t in your best interest. People turn down the first offer on their home waiting for a better one which doesn’t come.
If you feel that your decisions are being impacted by Loss Aversion then make sure you listen to the advice you are being given by the experts around you, particularly if it is a major decision.
The concepts we have covered are the pillars of Behavioural Economics. Once you are aware of them you can take action and put strategies in place to help you manage your way through them.
We have produced five short videos on Behavioural Economics – but we’ve called it ‘Why We do dumb Stuff!’
Feel like something is not right with you and money? Are you lying awake, staring at the ceiling, stomach churning? Give us a call or an email and we’ll have a chat. No obligations whatsoever.