Humans are not rational. Irrationality is the argument of behavioral finance, and the proof of this has been growing over the past two decades. Traditional finance theory is centered on rational humans participating in the markets. Rationality is a main driver of the efficient market hypothesis.
From a personal finance standpoint though, the findings of behavioral finance can help us irrational humans from putting ourselves in uncomfortable situations or help us trick ourselves into making better rational financial decisions.
Mental Accounting
Mental accounting is when humans place different values on the groups of the same things. In personal finance, these things are money. Researchers have found that we group money into three categories, salary, money in assets, and money saved for future. The money in each of these groups is the same. Still hard-earned greenbacks, but we treat them differently. When we need to purchase something, we will treat salary as easier to spend than the other two choices. Sounds simple and many of us do this by budgeting based on salary and not net worth or retirement savings.
The research shows that humans are more likely to make rational financial decisions when the money is not in the salary group. For example, when we receive a bonus, we are less likely to treat it like salary and more likely to assume that it belongs to the long-term savings group. Because of this, it is easier to add this money to a retirement account than it would be if that bonus were split up in our paycheck throughout the year.
This type of irrational thinking is defined as mental accounting. The money is the same regardless of whether our employer includes it in our paychecks or gives it to us as a lump sum bonus. However, we treat it completely different. Since we see the lump sum bonus as a different group of cash we are more likely to treat it like long-term savings.
Tax Refund Time
Everyone knows a big refund around tax time is the result of overpaying throughout the year. Many in the finance community, including me, see this as a short-term interest-free loan to the government. While I love the good ole US of A, I’m not into giving interest-free loans to anyone, even Uncle Sam.
This research has made me think about this refund from a different standpoint. Since we aren’t rational, if I want to guarantee that I allocate the amount of overpaid taxes toward a retirement account, I would be better off taking a large refund and overpaying throughout the year.
If I don’t overpay, then I receive this amount in my bi-weekly paycheck. It is considered salary through mental accounting, and it will be harder to hold back the urge to spend. By overpaying and receiving the lump sum refund, it is easier to justify dropping the entire amount in an IRA.
This makes a lot of sense, and while I consider my wife and me to be very good savers who have a tight leash on our spending, I will not deny that it would be easier not to spend this cash if we received it in a lump sum opposed to trickled through our paychecks.
This idea is similar to the “pay yourself first” mantra touted by finance professionals for years. It is easier to add to a 401k or your savings before the paycheck even hits your checking account than having to make the transfer manually after you cash the check. You don’t miss the money because, due to mental accounting, you don’t think it was ever yours. It belongs to your retirement. Cash grouped differently is treated differently by us irrational humans.
Knowledge is the first step
I find it interesting that no matter how much education is available about making correct and rational financial decisions, we are still human and these decisions are difficult to make. There is a saying that if knowledge were all that mattered, we would all be millionaires and be in perfect shape. Knowing is only the first step. Taking action and fighting human biases is the second and more difficult step.
Knowing that I am fighting irrationality, I try to do everything I can to avoid having to compete with my internal biases and mental accounting. I automate retirement savings and loan repayment, and this has made a significant impact on my path to financial independence. Maybe giving Uncle Sam an interest-free loan is a way I can force myself to use mental accounting for good instead of evil.
Join my email list and stay tuned for more ways to trick your brain into making good financial decisions.
photo credit: brain cc license
I’ve been thinking about this recently–it’s validating to see a finance professor write about it! I vowed to stop the big tax refunds this year. But then we got a big tax refund and used it to set up our estate plan. I doubt we’d have patiently set aside money over the course of the year to do so. So I’m reconsidering that resolution. I am worried about possible identity theft, however.
We are in the same boat. Whenever I receive a large tax refund or any cash windfall, it is always easier to apply this money to investments, paying down debt, etc. I was so happy when I read about these studies that I had to share the findings. The results fit my personal experiences so well. It’s nice to see that I’m not alone!
Identity theft is a concern, but there are many companies out there that provide identity theft protection so this risk can be hedged. Also, filing your return earlier helps minimize the risk of identity theft for taxes.