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  • Imagine a person who always makes the right financial decisions.

  • Let's call herPenny.”

  • 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 researchDumb 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.

  • [MUSIC]

  • 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 theendowment 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 getyour 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 gettheir 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

  • inflatedmanufacturer'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 Pennybut being pennywise is pretty good, too.

  • And that's our two cents!

  • If you want to hear more examples ofdumb 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.

  • [MUSIC]

Imagine a person who always makes the right financial decisions.

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