Hi Everyone! I hope you all had a positive week and a nice bank holiday weekend! I think I have not socialised in a long time, so I have just about recovered from all the interactions I have had this long weekend, but it was very nice to see family and friends again. We continue our money relationship series, and this week, I will look at how we might fall into mind traps about money.
Mental accounting is the tendency to value £ less than others based on 1) where your money has come from, 2) how it is to be spent or, 3) the size of the transaction. A way to illustrate this is to consider what are you more likely to spend – winning £10,000 in the weekly lotto or £10,000 you have saved painstakingly in the savings account?
For most people, spending the money from the Lotto is much easier to spend rather than saving, because there is a lot of emotion and sacrifice to save £10,000. This is mental accounting but we need to recognise that £10,000 is £10,000 no matter how the money was earned.
What to do – We should all consider that all money should be spent equally, more importantly, you need to be critical when mental accounting costs you money. If you have short term savings and credit card balances, pay off those credit balances first, because of the high interest you have to pay if you don’t clear it vs. the minimal amount of interest you are actually gaining from savings.
Loss Aversion is when people feel the pain that comes with loss more strongly than the pleasure that comes with an equal gain. It has been proven that it is twice as strong, which helps explains why investors have such a hard time selling losing stocks and bonds, or why homeowners have a hard time selling their house worth less than they paid for it – “negative equity”.
What to do – start limiting the significant loss aversion by considering investing in more passive options such as index mutual funds that require less thinking and action. The best thing is to rebalance the portfolio once a year. For the rest of the time just leave it alone.
People have a hard time moving money into saving plans because they feel the current loss of buying power stronger than the future gain of wealth building, to bypass this, you should set up a direct debit into a savings accounts/ISA and do not touch it. I have always recommended this to my family, check how much money you have made once a year – such as your birthday!
Sunk Cost Fallacy
The sunk cost fallacy is when you justify past expenditures with present decisions. Imagine you have been given tickets to see an art exhibition, it is super popular and you have been dying to go. Before you leave your house, you learn that the tube is not working and you can only get there if you ordered an Uber. Do you go?
Now imagine that the art exhibition is once in a lifetime exhibition and you had bought the tickets yourself (they were not gifted) – do you go?
The money for the ticket is spent, or in economic terms, it is a “sunk cost”, therefore, in either case, the decision should be the same – just because you paid for it, this should not change your decision whether to go or not. This is also the reason people continue to hold onto losing investments, because they focus on what they had paid for the investment, rather than evaluating what it is worth today and cutting your losses asap. Sunk Cost is “throwing good money after bad”.
What to do – you need to critically assess and tell yourself, you need to forget the past and how much you have spent. If that is too hard, ask someone who does not have an emotional investment and can give you rational advice.
Do you recognise any of the mind traps above? If yes, I hope the little tips help you recognise when that you have fallen into a mind trap. I would to hear about you experiences, so please leave me a comment below!
With Sweet & Sour Love,
Pineapple Chicken x