The end of 2019 is approaching and the end of the year usually means holiday shenanigans at work. But also potentially getting an end of year BONUS!? Getting a bonus feels awesome because you’re never quite sure exactly how much money it’s going to be and it’s really nice to have a surprising amount of money deposited into your account as a lump sum. But there’s a big problem with getting lump-sum bonus checks and that is, humans can’t help themselves and almost always blow right through lumps sums of money!
But, why does this happen? I mean, most people know what they’re supposed to do with money. We know we’re supposed to save money for emergencies and pay our bills, but once that check hits the account we feel like it’s our cue to go do some extra holiday shopping and to go treat yourself. If you pay attention to what’s happening with your brain, you’ll know exactly why we tend to do this and you might even be able to prevent yourself from blowing through your bonus when you get it! So here we go…
Richard Thaler is an award-winning behavioral economist whose paper, Mental Accounting Matters, details the ways that people think about money in different mental buckets to avoid feeling as bad about their losses or to make themselves feel better about spending. If you’re walking down the street and you happen to find a twenty-dollar bill on the ground, you’d pick it up and feel really lucky! You’d also be thinking that you just got an extra $20, the additional money that you didn’t expect to have or you didn’t plan on having. For some reason, this $20 lives separately in your mind from all your previously earned and stored money. In other words, it’s special money.
Thinking of this money as special leads you to believe that you can do special things with it and that you’d be justified in doing so. This same exact mental process happens when people get a bonus check at work. They think, “Oh, now I can get that expensive pair of shoes I wanted or take that pricey weekend trip because I have extra money.” But this type of thinking is a problem for a few reasons.
There’s an economic notion called “fungibility,” which basically means that all dollars that exist are the same, regardless of where they came from or how you ended up with them in your possession. The dollars that you have in your checking account or in your wallet are interchangeable with the dollars that you just found on the ground. They are literally indistinguishable and therefore should be treated that way in your mind and in your budget. You should use the new twenty-dollar bill just as you would use any other twenty dollar bill. If you’ve already decided not to use your money to buy a new pair of shoes, then why would you change your mind now?
Mental accounting violates the notion of fungibility, and therefore we need to be really careful about observing our own thought processes so that we can catch ourselves and use a more logical way of making financial decisions.
What to do about this
So, what do we do about this problem?
It is definitely a good idea to be informed by reading about lots of different examples of mental accounting that are common, but that doesn’t always make the most sense economically. This is one way that I’ve improved my own financial thoughts and behaviors because if I find myself or my close friends and family having thoughts or saying things that reflect mental accounting, I’m able to quickly recognize that they’re similar to examples I’ve read about and I can call it out and correct it.
For example, recently my good friend was explaining to me that she wants to decide between using flowers or candles to decorate her wedding venue. I asked which choice she prefers and she said that financially she’d rather go with the candles because she found a great deal online for bulk ordering white candles and it was well under her budget, but she was still tempted to get floral arrangements instead. The floral arrangements were significantly above her budget. She said, if I get a bonus from work this winter, then maybe I will go with the flowers. I asked her to explain why she would do that and she said, “because it’s extra money.”
“Extra” money – uh oh. I explained to her that she was thinking of the bonus as a special and separate bucket of money when in reality it was interchangeable with all the money that she already has. She and I talked about all the other ways that she could use her bonus check to improve her financial life and she agreed that thinking this way didn’t make the most sense, but it was hard to fight. That’s how mental accounting works! We do it over and over again throughout our lives until it becomes second nature and we don’t even realize that we’re not making sense.
Gladly, my friend decided that it would make more sense to pay off her credit card bill early, invest extra money in her IRA and save a bit more instead of buying those flowers.
I hope this post has inspired you to do the same! Not with candles and flowers, but with decisions you make every day with your own finances. And remember this post when your bonus check hits your bank account! You can use it to save more, pay off debt, invest or make a necessary purchase. When you’re faced with that next financial decision, hold your choice up to the light so you can really see it clearly and make sure it doesn’t violate the notion of fungibility!