July 2012: Mental Tricks

Dear Clients and Friends,

Summer is here!  For those of you who have not experienced it, San Francisco summers can be a truly brutal affair.  While people in other areas of the country enjoy warm evenings outdoors and sunny days filled with play, San Franciscans enjoy wind, cold and fog.  The brief three hours of sun in the middle of the day just leaves you wanting more.  All of this is compounded by the fact that if you drive 15 miles away from San Francisco in any direction it will most likely be sunny and warm.  Mrs. Bootstrap and I have dealt with this in the only sensible way we could imagine.  We moved!  As most of you probably all ready know, we have relocated to San Jose - about 30 miles south of the city.  Both for the weather and to shorten Colleen's commute.  Feel free to stop by for a barbeque!  Just in time for 4th of July.

I received more feedback on my last quarterly letter than I have on any other letter that I have written (click here if you haven't read it).  Most of it was along the line of... "Oh fudge, I really need to get my act together!"  But some questions were more along the line of, "OK, but HOW do I start saving more money?"  Which brings me to my topic this quarter...

Mental Tricks for Saving
(Or: How to Wage Psychological Warfare Against Yourself)

There is a burgeoning field in my industry called Behavioral Finance or Behavioral Economics.  It's a fascinating area of study that seeks to understand the cognitive and emotional factors that influence decisions around money.  Or to put it more succinctly: why we do stupid things with our money when we know we shouldn't.  If you are interested, two books that I would highly recommend: Your Money and Your Brain : How the new science of neuroeconomics can help make you rich by Jason Zweig and Thinking, Fast and Slow by Daniel Kahneman.  What this field has uncovered is there are systematic biases that get in the way of us making sound and reasoned choices about our finances.  But if we understand them, maybe we can outsmart... ourselves.

Thinking is Hard:

Kahneman has observed that we have two systems for making decisions.  System 1 is fast, intuitive and emotional.  An example of using system 1 might be how we decide what to have for dinner (or dessert).  System 2 is more deliberate, slower and logical.  An example of system 2 in action might be how we decide which job to take out of competing offers.  Which system do you want to use in your financial decision making?  System 2, right?  The problem is, using System 2 is harder.  It requires sustained effort, focus and willpower.  So we avoid using it if given a chance - even if only subconsciously.  This is why we spend so much more time researching our vacations than we do our investments.  If you are going to make a choice on where to focus your effort, you will pick something that you enjoy.  Unless you are strange like me - and you enjoy personal finance.

I think the key here is twofold: avoid making decisions based on short term news or "gut" feel.  Also, make sure when you do make decisions they are well thought out and articulated.  It's probably not a surprise that I think financial planning and regular yearly reviews are probably the most effective way to deal with this issue.  And this is true whether you work with an advisor or you manage your own finances.  For families, a quarterly spending and savings review can be very helpful to make sure you are staying on track.  Make sure they are scheduled in advance and you have sufficient time to talk through issues without having to make any quick decisions.  Documenting your actions doesn't hurt either - I'm not sure where it fits with behavioral finance, but crossing something off your to-do list sure feels good.

Mental Accounting:

Have you ever noticed, if you get a little extra money and you put it into your checking account, after a couple weeks, or months, it's just... gone?  This is due to mental accounting.  We have a tendency to assign our money to mental buckets.  Our 401(k) is for long term retirement goals.  And our checking account is for spending.  This is also why we have a tendency to blow "found" money.  Any tax refund, bonus or gift doesn't have a mental bucket.  If we put it in with our spending money...  Woo hoo! Party time!

I like to use mental accounting to my advantage.  I think it's very valuable to link specific goals with specific pots of money.  Once you set up an account and label it - either mentally or electronically - something like "house down payment fund", you are much less likely to blow it on a quick trip to Cabo with your buddies.  You can build as many of these types of accounts as you want.  For example, I have 5 separate savings accounts all keyed into different goals like travel, investing and monthly expenses.

Instant Gratification:

Obviously, instant gratification stems from our System 1 & 2 thinking.  I imagine this was very useful for our ancestors on the savannah.  If you were the first to grab a juicy pomegranate, well then, it was highly likely that you would be able to survive for another day.  And since most of our decisions are made with System 1, it would be pointless to assume that we could dispassionately weigh all of our choices to come up with an optimal answer.

In this case, I like to use what I call the "two-thirds rule".  I've used this technique successfully myself for many years.  Here's how it works: whenever I get "found" money, I save two-thirds.  The other one-third I spend - immediately.  This links the surge of pleasure you get from spending a chunk of cash with the process of saving.  It makes the delayed gratification of savings much less painful to know that you get some fun money too!

In Closing

There are many more biases that affect our ability to manage our finances, but hopefully some of these mental tricks can help you meet your long term saving and investing goals.  Next quarter, I'll talk about another topic to help you save: how to maximize your company benefits.  In the meantime, if you have questions about these savings tricks, don't hesitate to contact me.  Also, if your friends or family have questions about any financial issue, please feel free to make an introduction or forward this letter.  We provide Financial Planning and Investment Management services and would be happy to talk with your acquaintances.  We will treat your friends and family with the same care and diligence that we treat you.

Thanks,

Brian McCann, CFP®