"A penny saved is a penny earned."
I'm in my early 20s visiting a casino, even though I don't go to casinos often. I'm traveling and this new casino has free blackjack lessons. How convenient, I think, that a casino would teach me how to play a casino game for free. I'm pretty naive, but I'm having fun. I learn basic strategy and my new knowledge leads me learn a little about altering my bet based on how many big cards are still in the deck (this could be called a basic form of card counting).
I'm not a high-roller; I stick to starting with $20 and usually that lasts a while before I lose it. Some days it doesn't last long and get bored, usually forking over another 20 bones. But on one particular day I find myself playing blackjack in a high-stakes room. I started the day with my $20, but now I have $300! I think to myself, "Dude, you still have your $20, plus you $280 of their money. Why not see what this high-stakes stuff is all about."
I would never take $300 and walk into a high-stakes room at a casino, yet here I am. Why would I gamble with $300 on this night but never do on any other night?
The Mental Accounting Problem
The source of our money shouldn't have any influence over how we view that money. Nor should the use of our money. The unfortunate truth is that both the sources and uses of our money alter how we view it. The experts call this mental accounting, where we put money from different sources and for different uses into various buckets and treat each bucket differently.
Do yourself a favor and ask yourself what you would do with an unexpected bonus. Be honest. If you are like most people, there would be a splurge. You would take a trip that you wouldn't have otherwise taken, or purchased a "toy" or other item that you otherwise wouldn't have purchased. Maybe you take your bonus and update your home that you wouldn't have updated for a few years.
It's not just sources and uses of our money, either. With investments, it's common for people to have different portfolios, or baskets of investments, set up for each of their goals. They may have a set of investment for their retirement accounts, maybe a different one for their fun money, and a third set of investments (these sets of investments are called asset allocations) for their health savings account. By doing this, we run the risk of failing to fully diversify our overall investment allocation.
The purpose here is not to criticize or judge. The purpose here is to let you know that this is something that everyone does.
Money Is Treated Differently
As Benjamin Franklin famously said, a penny saved should be treated as a penny earned, but we don't treat money that way. We treat money that comes from our paychecks different from money that we've currently got saved, and we even treat both of those differently from money we'll earn in the future.
There's a concept called the house money effect, and it's what I fell victim to in my blackjack days. The idea is that we treat winnings differently than our original money. We have a natural tendency to fixate on the amount of money we started with. If we end up winning money, the tendency is to view that money as money that we can blow. We don't care, we think, because it's not my money - it's the house's money! This is how we view an unexpected bonus, or even an expected bonus. "Hey, we didn't have this money before and now we do!" I know you're thinking this is completely normal and not even cause for concern. I also know that you think that because this effect is so common. A better way is to view our money as our money, no matter where it came from or what it's for.
Once I made my $300 at the casino, I should have viewed this as my $300 instead of $20 of mine plus $280 of theirs.
Since mental accounting is so strong we can use it to our advantage. Psychologist, author, and professor Brad Klontz has shown that by specifically labeling, and even attaching pictures to different accounts, we can increase our savings rates because this appeals not only to our emotions, but it takes advantage of this mental accounting effect. In terms of emergency funds and other rainy day money, if we have separate accounts and sub-accounts set up, we can hack our brains and essentially trick ourselves into not only saving into these accounts, but saving more for these goals.
With investing, we can set up different "buckets" for survival money, safety money, aspirational money, and so on. When we do this we can assign a different asset allocation to each bucket because the ability to take risk is different for each goal. The end result will resemble a fully diversified portfolio, but it was constructed in such a way that we are more likely to stick with it and keep contributing to it.
If anything I mentioned here happened to you, know that you're not alone; this is something we all do. But just knowing about this tendency can go a long way towards changing how we view money, no matter where it came from or where it's going.
Dan Ariely, Jeff Kreisler: Dollars and Sense
Daniel Kahneman: Thinking Fast and Slow
Michael Pompian: Behavioral Finance and Wealth Management
C. Yiwei Zhang, Abigail B. Sussman: "The Role of Mental Accounting in Household Spending and Investing Decisions" in Client Psychology
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