When Rich, When Poor...



You have just been paid. Sweet. Time to treat yourself! Time for dinners, drinks, clothes. Maybe it isn't even that drastic. It might not even be that hedonic. Maybe it's just the fact that all the extra money makes you more likely to judge the waiting time for the bus as too long. Maybe all that money makes ordering an Uber seem more justified. Maybe... Now imagine it not being payday, but the week before. Ordering an Uber? You might be in a hurry, and waiting for a bus that won't be on time is awful, especially when it's this cold and wet, but to be quite frank, you don't think it's a good idea financially. Your bank account kind of doesn't allow for it. These have to be very two familiar scenarios to all of us. They are definitely to me, because they are my own experiences (I am not ashamed to say). But why does this keep happening? Within behavioural economics we are aware that all decisions are based on a reference level. Prospect Theory (both orginal (OPT) and cumulative (CPT)) as proposed by Kahneman and Tversky use reference level dependency as a key staple in explaining how people perceive gains and losses. However, even in their model this reference point is not defined. It is assumed to be known to the individual, but not mathematically defined, whereas the formulas for the gains and levels, relative to the reference point are. Odd, because it does seem to be very important.

What is going on here? Why do we blow through money when we get paid? Well, although spending is very much an absolute thing, we spend relatively. Paying $8 for an Uber doesn't seem to matter too much if you have just been paid $1500. But if you only have about $100 left, and that needs to see you through another week, $8 is just too much to spend. Instead of spending .53% of your income, you're spending 8%. Talk about a rapid increase.

So, the starting point matters. Hardly surprising, we have known that for years, but it seems to have been not that well developed in behavioural theories. For example, another theory, quite well-known, is that of tightwads and spendthrifts, proposed by Loewenstein and colleagues. This theory is partly based on the pain of paying, which was brouhgt to life by Zellermayer when working with Loewenstein. These theories assume that paying hurts (invokes negative feelings) and that there are ways to manipulate the levels of pain experienced. One way of manipulating these levels would be the payment method used, and the time of paying (before, during, or after consumption). However, people as individuals have different reactions to spending money. Some experience a lot pain and can hardly part with it (tightwads) and some hardly experience pain at all, meaning they are quite uninhibited when spending (spendthrifts). I am sure all theories mentioned above are sound (my own PhD is based on them, so they better be...). But, I am wondering if they are complete. Because I genuinely expect that even a spendthrift hurts just a tiny bit more when spending their last money, rather than their first (assuming they aren't compulsive shoppers). So shouldn't we make use of that?

Another issue we might be facing is the fact that this seems to be a very cyclical behaviour. It is because we have to abstain towards our payday, that we feel the need to reward ourselves for our abstinence. Our brain craves it after so much withholding. If we hadn't abstained, the need for the reward wouldn't be so pressing. But then again, if we hadn't abstained, we wouldn't have made it till the end of the month. Financially that is. So the cycle continuous, vicious as it is. I suppose the question then becomes, how do we fix this? We know where we are going wrong. We know the vicious cycle we get into. Well, we'll have to break it. Next payday it is time to "fake poverty." I mean no disrespect, but you can create the feeling of being in your last week, just before payday. It is rather easy: you cannot have the entire sum of money you just have been paid in the place where it is easiest to spend. As such, move the majority of it to a place where you'd much rather it stayed, such as a savings account. People do not like moving money away from their savings. It almost feels like stealing. From yourself, that is. If you are scared to get into the habit of moving money out of savings into current, create some type of a midway account. But of course, only keep the money you are actually willing to spend in this account. Your savings should be moved to a savings account asap (Save First!). This genuinely increases the likelihood of you saving whilst also increasing the actual amount being saved. How do you determine how much to put into this current account or midway account? Well, it depends on how much you think you'll spend, or allow yourself to spend, per a certain period of time. Moving money around every day is tedious. So maybe every week? Give yourself a budget for each week, move it onto the current account and Bob's your auntie. At the beginning of the new week you can fill the account again, but only to the limit you set yourself earlier. So, instead of always moving $200 to your current account, you will make sure the current account has a balance of $200 at the start of each week. There is a difference, as you can have money left. If you had money left in the current account, I suggest you move it to savings. That'll count as a reward for your brain as well. Now this should control for most of the reference level dependency issues. When it comes to the "reward" for doing well, try figuring out non-financial ways of celebrating. "If I save $X, I can buy that expensive pair of shoes," is still splurging, but with the added dopamine shot of having reached your goal. To have saving linked to spending in this way reinforces the habit you are trying to break: unnecessary splurging, and as such is very ineffective. It doesn't mean you can't spend any money, just not the type of splurge most people have in mind. "If I save $X, I can go see that movie with friends," links an experience (that does cost money, but a lot less) to having achieved a goal. It almost takes the financial side out of it. Which is good. So, to sum up: keep the balance on your current account low, and incentivise yourself with non-financial rewards. Happy Saving and Spend Wisely! One quick note: do watch out for direct debits and overdraft fees. If you have a lot of standing orders on your current account, make sure you know when they are. Preferably they'd be set as soon as you get paid. When keeping the balance on your current account artificially low, you might hit overdraft if you fail to take this into account. Hitting overdraft will cost you money, which is the opposite of our goal. So, when making your weekly budget, take this orders into account. Another way of dealing with them is to have them on a seperate account altogether, to which you always pay the exact amount due each term. Whichever you choose, be mindful of where your money goes!

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