Financial Planning « One to One Group – Financial Management, Accounting & Risk Services

By: One To One Financial Management  06-Dec-2011
Keywords: Emergency Funds

Economics is known as the dismal science

This joke might explain why. Three economists went out hunting, and came across a large deer. The first economist fired, but missed, by a metre to the left. The second economist fired, but also missed, by a metre to the right. The third economist didn’t fire, but shouted in triumph, “We got it. We got it”.

While the impression of economists success rate in determining the future direction of economic activity might seem hit and miss at best that is not where the term dismal came from. It appears that it was first used by Thomas Carlyle in a December 1849 article. His comments had much more to do with his disagreement with certain economic principles of the time than being disparaging of economists generally.

It is easy however to be disparaging of economists. For instance, in their supposed role of making weather forecasters look accurate. But if you consider the world we live in – every day millions of people interacting to create literally billions of economic transactions – it’s not an easy task they undertake.
They play a valid role in other areas however. They help us to understand how those human interactions and activity work.

Interesting mental accounting

Consider this story: A husband and wife spend a night in Las Vegas and the man tries his luck at the casino. He vows not to wager more than $5. So he puts his $5 down – on his lucky number, 17 – and wins. He keeps betting on number 17 and he keeps winning, so much so that towards the end of the night he is up more than $10 million. He decides to wager it all one last time on number 17. But this time he loses, and his $10 million gain is gone in an instant. When he returns to his hotel room, his wife asks him, “How did you do?” “Not bad,” he replies. “I only lost $5.”

That’s interesting mental accounting. As far as the gambler was concerned, the only money that was really ‘his’ was the initial $5. Yet he still lost $10 million. The same kind of thing happens in our day to day financial lives. Researchers conducted an experiment in which two groups of people were asked to bid on tickets to a basketball game. One group had to pay cash, while the other could pay by credit card. The average credit card bid was twice as high as the average cash bid. Why? Credit card bidders felt richer because they didn’t have to fork over any actual cash. It has certainly been known in our household that getting an item on sale somehow created a saving that could be proactively spent as a treat – invariably the same afternoon.  Say what!

It is important to look at the big picture

People tend to mentally compartmentalise their wealth. If they have $1,000 held back as emergency funds and $1,000 in credit card debt, at 18% interest, many wouldn’t  touch the $1,000 in savings because it’s for ‘emergencies.’ But if it was used to pay off credit card debt, they could save the 18% in interest charges, which amounts to $180 per annum. They could then use that $180 to start rebuilding the emergency fund and still have the credit card for backup.

Keeping untouchable money in mental accounts like ‘home down payment’ or ‘emergency fund’ can be a good thing of course. The trick is to ensure that our individual mental accounting tricks are working in our favour.

The information in this article was current at 02 Dec 2011

Keywords: Emergency Funds

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