Do you like a good magic show? A talented, entertaining magician can create mind-boggling illusions. Little do we know, we do the same—all the time. How else can we go from excellent financial fitness objectives to uninhibited swipes of a credit card in just a few hours? “Now you see it… Now you don’t …”
Our brains often play tricks on us—but by understanding how we think, we can trick ourselves into putting the phenomenon of mental illusions to work! Used correctly, they can help us build wealthy habits and reach important goals.
Optical—and Mental—Illusions
Anybody notice a full moon? When close to the horizon, the moon usually looks much bigger than when it’s high overhead. This has baffled people for decades, but it’s actually an illusion. The moon never changes size, and its distance from the earth is relatively constant.
When the moon is near the horizon, our brain takes into account the earth’s proximity, so the moon looks big. High in the sky, there’s no comparison point, so the moon looks more like actual size on our retina.
Here’s another interesting trick: In the graphic to the right, the orange circle on the far right looks bigger, even though the two orange circles are actually the same size! You can even measure to be sure. Just like the moon, our brain compares the orange circles to their surroundings to determine their size. Though we know the moon’s size and the size of the orange circles are illusions, our brains still have difficulty accepting that. How can we make this quirk contribute to our financial fitness?
Mental Accounting
Mental accounting is about how we think about money. We tend to group money into different mental categories for different purposes, labeling them in our heads. My mother took this a step further by keeping cash in various pockets in her wallet and purse. She designated one for groceries, one for emergencies and one for her weekly mahjong game. Perhaps your family does something similar.
From a rational point of view, a dollar is a dollar, regardless of how we receive it or label it. Despite this, our brains accept the illusion we create for ourselves with mental accounts.
Downside
Here’s how the illusion can detract from financial fitness:
- We’re more likely to blow a windfall—like an inheritance or lottery winning—than money received in a regular paycheck. Tax-return and bonus money can also spend very fast!
- We’re more willing to use a credit card than part with the equivalent cash.
- We’re more likely to spend investment dividends than appreciation in value.
Is this “free money”? Personal finance says all dollars are the same, but our minds don’t.
Positive Results
While it can influence us to act unwisely, mental accounting can also help us achieve important financial fitness goals. For example, we’re less likely to spend money we label “retirement” or “kids college account” on a plasma screen TV.
Similarly, people who save too well and miss opportunities to enjoy life in the present can designate an account as “fun” or “spoil yourself” as an incentive to live it up a bit more. Anyone who has a parent or grandparent who lived through the Great Depression or in poverty has probably noticed this tendency toward extreme frugality.
Mental accounting pays great dividends as a tool for self-control. We trick ourselves into wealthy habits and doing the right thing! Budgeting methods are rooted in mental accounting, because we know we’ll spend one piece of the pie on food, another on transportation and soon. By reserving each category for its purpose, bills get paid and the entire paycheck doesn’t go out the window on a whim.
A key principle behind Moneymentals is to work with, rather than try to change, our human nature with respect to financial goals. Take a little time to understand yourself and how you mentally position your finances, and the recommendations in this course can help you do some good money magic!