Not All Dollars Are Created Equal

Why Smart People Make BIG Money Mistakes!

This is one of the books I like the most and would recommend to readers who intend to learn more about “ Behavioral Finance “ in a more practical and laymen terms.

A fascinating and practical manual: Looking at the ways we spend, save, borrow, invest, and waste money. It explain why so many otherwise savvy people make foolish financial choices, like why investors are too quick to sell winning stocks and hold on to the losing shares , why borrower pay too much credit card interest and savers can’t save as much as they would like and why so many of us can’t control our spending.

The book opens with one of the biggest psychological traps that people fall into – the idea that dollars aren’t created equal and that there are times where they treat a dollar with more value than at other times.

 Here’s an example: let’s say you were about to buy an item at Store A that cost $100, but you found out that the same exact item is being sold at Store B for $50. Would you switch stores? Now, let’s change it a bit – let’s say the item at Store A cost $3,050, while the same exact item was on sale at Store B for $3,000 – would you go to the other store then? Most people would do it the first time, but not bother the second time. Why? They look at the percentage, not at the actual dollar amount, meaning that the dollars themselves actually have less value to them.

The authors refer to this as “mental accounting,” and it explains why people often keep gambling when they’re ahead (the money isn’t real) and why people are much more likely to blow $50 found in a parking lot than blow $50 they worked hard to earn. Or, for example, people maintain a revolving balance on their credit card while keeping cash in the bank – the cash in the bank is more “important” than the cash going down the credit card rat hole.

                                            

Concept explains: Mental Accounting ( Wikipedia )

A concept first named by Richard Thaler, mental accounting (or psychological accounting) attempts to describe the process whereby people code, categorize and evaluate economic outcomes. People may have multiple mental accounts for the same kind of resource. 

A person may use different monthly budgets for grocery shopping and eating out at restaurants, for example, and constrain one kind of purchase when its budget has run out while not constraining the other kind of purchase, even though both expenditures draw on the same fungible resource (income). Similarly, supermarket shoppers spend less money at the market when paying with cash than with their debit cards (and credit cards), even though both cash and debit cards draw on the same economic resource.

A dollar you bet in The casino is not equal to a dollar you spend in Supermarket

The story ….

 “By the third day of their honeymoon in Las Vegas, the newlyweds had lost their $1,000 gambling allowance. That night in bed, the groom noticed a glowing object on the dresser. Upon inspection, he realized it was a $5 chip they had saved as a souvenir.

Strangely, the number 17 was flashing on the chip’s face. Taking this as an omen, he donned his green bathrobe and rush down to the roulette table, where he placed the $5 chip on the square marked 17. Sure enough, the ball hit 17 and the 35-1 be paid $175. He let his wining ride and once again the little ball landed on 17, paying him $6125.

And so it went until the lucky groom was about to wager $7.5 million. Unfortunately, the floor manager intervene, claiming that the casino didn’t have the money to pay should 17 hit again. Undaunted, the groom taxied to a better-financed casino downtown. Once again he bet it all on 17, and once again it hit, paying more than $262 million. Ecstatic, he let his million ride – only to lose it all when the ball fell on 18.

Broke and dejected, the groom walked several miles back to his hotel.

“Where were you?”  as the bride as he entered their room.

“Playing roulette.”

“How did you do?”

“Not bad, I lost five dollars.”

Mental accounting of credit cards and cash payments.

Another example of mental accounting is the greater willingness to pay for goods when using credit cards than cash, and buy more goods when paying with a debit or credit card than with cash. If people use a credit card to pay for tickets to a sporting event, they will tend to be willing to pay more than if they make their bid with cash. This phenomenon is also related to a transaction decoupling, the separation of when a good is acquired and when it is actually paid for.

Another example :

Bonuses

We treat our “tax refund “, “birthday money” or Bonuses differently from normal income or paycheck .” The very name – “bonus” – suggests a sum of money meant to be seen in a different light than mere ordinary income. Unsurprisingly, many employees are seen spending their bonus money on things they would never be able to justify (to their spouses or to themselves) spending “regular” income on – boats, new cars or lavish vacations, for instance. Of course, nothing says that these types of purchases are bad or irrational. Far from it!

The issue at hand is that all spending – extravagant spending included – should be consciously compared with what the money could alternatively be spent on. If your current financial plan already includes extravagances, feel free to spend bonus money on it! If not, the fact that you have received “a bonus” does not change the other, less exciting things you know are factually more deserving of that money.

As quoted by Adarsh Gopalakrishnan: “A bonus or tax refund cheque is money you’ve earned. It’s not a gift from God or money from the sky…. A credit card needs to be paid. It is not a gift from a rich uncle….

Another "Classical case ":

Game: Classical Theater Problem

Case 1: Imagine that you have decided to watch a movie tonight and you already purchased a ticket for $10. As you enter the theatre, you discover that you have lost the ticket. The ticket office tells you they keep no records so you will have to purchase a new ticket to see the movie. Would you still pay $10 for another ticket?

Case 2: Imagine that you have decided to watch a movie tonight and the ticket is $10. As you enter the theatre, you discover that have lost $10 bill on the way. Would you still pay $10 for a ticket for the movie?

This is the Kahneman and Tversky (1984) classical theatre ticket experiment. In their paper, 200 participants participated in the experiments. In the first case, 46% replied “Yes”, and 54% replied “No.” Meanwhile, in the second case, 88% said, “Yes,” and only 12% chose “No.”

Why are people so much more willing to spend $10 when they lost $10 in cash, versus when they lost a $10 ticket? The answer is that people have a mental “movie ticket” account and when they have to buy a second ticket, they impute a total cost of $20 to the aggregate movie ticket transaction, and this is perceived as too much. The loss of cash, however, is perceived at the portfolio level of net worth, which is independent of the mental movie ticket account.

Another example from: Richard H. Thaler, author of (Misbehaving: The Making of Behavioural Economics)

“Mr and Mrs J have saved $15,000 toward their dream vacation home. They hope to buy the home in five years. The money earns 10% in a money market account. They just bought a new car for $11,000 which they financed with a three-year car loan at 15%.”

Mr and Mrs J have effectively borrowed $11,000 at 15% and are reinvesting it at 10%, structurally locking in losses of 5%.

For example, if the couple simply took $11,000 from their $15,000, the cost of that $11,000 is the opportunity cost they forego, which is 10%–the amount they would have earned in the bank account–however, by taking out a loan of $11,000 at 15%, they invest $11,000 @ 10% in the bank account, “saving” for the house, and simultaneously borrowing 11,000 @ 15% to buy the house. On net, they are locking in a 5% cost on $11,000. 

To combat mental accounting bias, therefore, it is important to recognize the “fungibility” of money—that is, that all money is the same. Whether it has been won, earned or realized as profit, viewing that money’s origins as irrelevant will help cut down on unnecessary spending habits in the future.

 It will also eliminate many losses that come on the back of profit. Imagining that “all income is earned income” is one specific way to cut out expensive expenditures ( holidays ). Not applying labels or creating specific mental accounts, moreover, will also help to stop sub-par investment decisions from being taken.

Cheers!

Quote Of The Day:

“ To break a mental model is harder than splitting the atom. “ by Albert Einstein