Behavioral New World
August 1, 2021
Money Illusion, part 2—The Bucket List
You may already have a bucket list, things you’d like to do before you kick the proverbial bucket. But I’d like to introduce to you a different type of bucket, one used by behavioral economists. Let me start with a story.
I have a credit card that gives me “cash back” credits that can be spent on many different websites, so the cash back credits are almost as good as money in the bank (unlike, say, a department store credit which can only be spent at that store). Alternatively, I can apply the cash back credits directly to my credit card balance, making them just as good as money in the bank.
My most recent credit card statement showed that I had $250 in cash back credits. So, when ordering something on popular website, I decided to use some of the $250. As I was doing so, I noticed that it didn’t seem to me like I was spending “real” money. It felt more like free money—just click the “Apply credits” button and “Balance due = $0” popped up. It was pain free; it didn’t feel like I was parting with money.
But that’s an illusion. Because I could have reduced my credit card balance by $250, the credits are just as good as cash. But it certainly didn’t feel that way during my online shopping. I may even have bought a more expensive item because I had the cash back credits. I think you can imagine that spending the credits is somehow more rewarding than merely reducing the balance due on your credit card—not much satisfaction there.
I call this phenomenon the “free money” illusion. Another example:
Imagine that you find a $100 bill on the sidewalk. You might say, “Free money! I’m going to treat myself to something special.” But the $100 is no different than $100 in your bank account (economists say that money is “fungible”—one dollar is as good as the next one). The money is not free. But spending it on a special treat comes easier than spending $100 of your hard-earned money on the same treat.
Your decision to treat yourself with the found money is a type of “mental accounting.” As the phrase suggests, mental accounting consists of filing money into different “buckets” for different purposes. The cash back credits go into a “online shopping” bucket. The found $100 goes into the “treat myself” bucket, and so forth.
How many money buckets do you have? Quite a few, I suspect, although most people are unaware of their buckets. Mental accounting can be helpful—think of your household budget. But it can also lead to money illusion and less-than-optimal decisions. Perhaps the found $100 would give you more satisfaction spent (or invested) elsewhere, if only you had thought of it.
In describing this type of money illusion, I am NOT saying that you shouldn’t treat yourself with the found $100, or that you shouldn’t use your cash back credits to buy things. I AM saying that you should realize that, in spite of what you are feeling, using a cash back credit is no different than writing a check. The check hurts more than the cash back credit, but financially they are equivalent.
In fact, there are higher-level buckets that float somewhere above your personal buckets and dump into them. What do I mean? Consider these forms of money:
Cash
Checks
Digital money on a website
Digital money on a smart phone
Subject to money illusion, we tend to treat all of these differently and, critically, money departs our hands more easily as we go down the list. That’s why some financial advisors suggest that you use cash whenever possible—because it hurts more, you spend less. This advice would be unnecessary if we weren’t subject to money illusion. But we are. Our challenge: When are money buckets useful (e.g., budgeting) and when not (e.g., found money better spent elsewhere)?