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.

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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.

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