Imagine a person who always makes the right
financial decisions. Let’s call her “Penny.” Penny approaches every money problem with
perfect logic and reason. She never gets emotional or impulsive and
always knows what’s in her own best interests. You’re probably thinking that Penny sounds
imaginary (and kind of obnoxious). But for over a hundred years, most economists
believed that the world was made up entirely of Pennys. That you and I and everyone you know always
made the best decisions to maximize our happiness. As crazy as that sounds, that was the conventional
wisdom... until a small group of economists and psychologists started to question whether
Penny actually existed at all. One of them, Richard Thaler, won the Nobel
Prize last year for proving that not only do humans make financial mistakes, they make
predictable mistakes. He joked about calling his research “Dumb
Stuff People Do,” but today it’s called behavioral economics, and it has changed public
policy across the world. Thaler showed that humans can’t quite remove
their emotions from the decision-making process, but being able to predict these money mistakes
might help YOU avoid them. [MUSIC] Let’s say you’re helping your mom clean
out the garage and you find a pack of Pokemon cards that you must’ve bought when you were
a kid and forgot to open. So you go through them and HOLY COW there’s
a first edition Charizard in mint condition! Even though you could easily get $3,000 on
ebay for it, you decide to buy a frame and keep it on a shelf in your apartment. Okay, let’s rewind and consider a different
scenario: Instead of helping your mom clean the garage, you decide to go to the comic
book store. There in a glass case you see a first edition
Charizard card priced at $3,000. Even though you used to love Pokemon, you’d
never dream of shelling out that kind of dough for a playing card, and you leave the store. This may seem like understandable behavior,
but it’s completely irrational. In the first scenario, you’re deciding that
a Charizard card is worth giving up $3,000 for, but in the second scenario, you’re
deciding a Charizard card is not worth giving up $3,000 for. To a perfectly rational being like Penny,
whether or not you already own the card should be irrelevant when judging its value, but
clearly to humans like you and me, it’s very relevant. Thaler called this the “endowment effect,”
our tendency to assign more value to the things we already own than the things we could own. Any time you refuse to sell something for
an amount that’s more than you’d pay for it, you are experiencing the endowment effect. Ugh, this movie is awful! I know. Let’s watch something else. We can’t. Why not? Because I paid 6 bucks to rent this movie! We can’t just throw that money away! Ugh! You burned the popcorn! Well, we have to finish it. That bag cost 89¢. Have you ever watched a movie you hated all
the way to the end or finished a meal you weren’t enjoying, just because you paid
for it and you wanted to get “your money’s worth”? If so, you have fallen victim to the SUNK
COST FALLACY. It’s not like sitting through the Emoji
Movie will magically refund the rental price--that money is sunk, and it’s not coming back,
so why put yourself through the extra pain? Most of us keep an emotional balance sheet
in our head, which is less concerned with actual gains and losses than the feeling of
gains and losses. Even though watching the movie makes you less
happy, at least if you sit through it you don’t have to count that $6 as a loss in
your mental checkbook. Our fear of sunk costs is so great that businesses
can use it to squeeze even more money out of us. Many retailers sell "memberships" that include perks like discounts and free shipping. They know some many people will buy extra
stuff they don’t really need, just to make sure they get “their money’s worth”. Imagine that you’re shopping for some headphones
and you’re about to buy some for $15, when you find out that the store down the street
is selling the exact same pair for $10. It’s just a ten minute walk. Would you do it? Now, same scenario, but this time you’re
shopping for a laptop. The first store has the model you want for
$675. The second store $670. Now do you take the walk? Many people will answer these two questions
differently, even though they are essentially the same question: Is it worth $5 to take
a 10-minute walk? All other context should be irrelevant. Yet people are more likely to say yes to the
first scenario, because it feels like you’re getting a better deal. This is called transaction utility, the amount
of mental pleasure or pain we get from feeling like we paid less or more than something’s
really worth, and it’s often totally disconnected from the happiness you get from the thing
itself. Stores have been exploiting transaction utility
from time immemorial, like the notoriously inflated “manufacturer’s suggested retail
price,” which makes it look like every item is always on sale. And some shoppers are so addicted to transaction
utility that they’ll fill their houses with stuff they don’t need and will never use
just to chase that bargain high. Of course, it’s always important to shop
around to find the best deal, but remember that when considering any purchase, the only
thing that matters is what it’s worth to you. If you won $100 on a lottery scratcher, what
would you do with the money? Buy an expensive pair of shoes? Go out for a fancy dinner? Most people say that they’re more likely
to spend unexpected income on something indulgent or frivolous, because hey, it’s not like
I worked for that money. It was free! Thaler called this kind of thinking mental
accounting, which means separating money into imaginary categories in your mind. Mental accounting violates the rule that money
is fungible--that is, totally interchangeable. Once you own a dollar, it’s the same as
any other and shouldn’t be treated differently just because of where it came from. For Penny, that pair of shoes is either worth
giving up 100 dollars, or it’s not. Just because some money unexpectedly showed
up doesn’t make the shoes worth more. Mental accounting can be helpful in making
monthly budgets and sticking to them, but even then it can lead us down irrational roads. One study focused on how consumers reacted
to a drop in gas prices from 4 to 2 dollars a gallon. This was at the beginning of the 2008 financial
crisis, so you’d think most families would’ve had a lot of use for that extra 40 bucks a
week. Instead, researchers found that people were
surprisingly likely to squander those savings on a higher grade of gas! It’s as if in their minds they had budgeted
a certain amount a month to gas, and so it had to be spent on gas. They couldn’t treat the money as fungible. Mental accounting exists for the same reason
a lot of fallacies do: because our brains aren’t perfect supercomputers and we use
a lot of mental shortcuts and emotional instincts just to get by. But knowing what those shortcuts are will
make you less likely to rely on them in the future. You may not ever be as wise as Penny… but
being pennywise is pretty good, too. And that’s our two cents! If you want to hear more examples of “dumb stuff people do,” check out Richard Thaler’s Misbehaving: The Making of Behavioral Economics. It’s a funny and fascinating history of Thaler’s research, full of surprising studies that will inspire you to think differently about money. [MUSIC]
