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5 Ways You Fool Yourself into Spending too Much

Writing for Time a dozen years ago, I somewhat harshly picked on a 22-year-old groundskeeper who grabbed the baseball that Mark McGwire hit for his record-breaking 62nd home run in 1998.

A misplaced sense of duty had led the young man to give the ball to McGwire after the game, even though the ball legally belonged to whoever caught or recovered it -- and probably had a value well in excess of $1 million. We may never know the actual value; McGwire gave the ball to the Hall of Fame. But the slugger's final home-run ball that season (No. 70) fetched $3 million at auction.

The groundskeeper, I pointed out, was a victim of "mental accounting." Recovering the ball was a stroke of luck; it was found money. So he didn't feel like he was losing anything when he gave it away. Yet money is money, no matter how it is obtained. Can you imagine this young man giving away $1 million (to a multi-millionaire, much less) that he had saved through hard work and discipline? Well, it's the same thing, exactly. Really. Heck, imagine him giving away $1,000 or even $100 that he had actually worked for.

I've often wondered, in the years since, how this young man came to feel about giving away such a valuable item. My guess is that, now in his middle 30s and likely struggling like most of us to save for retirement, he has his regrets.

The economist Richard Thaler pioneered the notion of mental accounting and has tried to explain how this kind of thinking sets individuals back financially. He believes that consumers consciously or subconsciously compartmentalize spending into buckets (entertainment, food, gas, etc.) and place limits on each bucket rather than seeing their spending as a whole. So even if they exceed their budget on entertainment one month, they don't necessarily adjust their spending on, say, groceries to make up the difference. Long-term, this leads to excessive spending and erodes savings.

Thaler further suggested that consumers mentally label money as earned (which they dispense carefully) and found (gift, lottery, home-run ball; which they may fritter away mindlessly). Think of hitting the jackpot in a casino. The typical recreational gambler will see the winnings as "house money" and play until it is gone. Casinos count on it. Yet money is money. Gambling winnings is no different than gambling money you saved.

A new study by Justine Hastings at Brown University reinforces the potentially destructive nature of mental accounting. Looking at gas prices and consumer behavior, she found that consumers overwhelmingly shift to lower (cheaper) grades of gasoline when gas prices rise but that they do not do the same thing when gas prices are stable but their income declines, which has the identical effect of making premium gas less affordable.

Consumers, it seems, have an idea of what they are willing to pay for gasoline each month and they stay with it as best they can. When it comes to rising gas prices, writes James Surowiecki, mental accounting is especially harmful to the economy as consumers grossly overestimate the impact on their finances.

Mental accounting costs you money in many ways. "It's important that you learn to view all money equally," write Gary Belsky and Thomas Gilovich in their book Why Smart People Make Big Money Mistakes. "The more time you have to think of money as savings -- hard earned or otherwise -- the less likely you'll be to spend it recklessly."

You know you are at risk of faulty mental accounting when:

  • You have money in the bank but carry a credit card balance. (Your net worth is the same if you pay off the cards, and you'd save interest expense going forward.)
  • You use plastic even though you have cash in your wallet. (The price of the item is no different -- only your perception of what you are paying when you charge it.)
  • You spend your tax refund or large cash gift on a luxury item even though your bills aren't paid. (You wouldn't spend earned income this way.)
  • You won't buy a second $10 movie ticket after losing the first; but will buy a $10 movie ticket after losing a $10 bill on the way to the theater. (You're out $10 either way.)
  • You'll drive 15 minutes out of your way to save $10 on a $30 item but not to save $10 on a $300 item. ($10 is $10.)
In most cases, mental accounting errors aren't huge -- like giving away that $1 million baseball. But they chip away at your ability to save month in and month out, which is the only way most folks have a chance at achieving financial security.

Photo courtesy Flickr user 87913776@N00
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