Our last blog talked about the simplest way to start saving: set up a regular automatic transfer from your salary account into a separate saving account. “Save before you spend”, we called it. We didn’t make that up. There are well-studied psychological principles that make this simple technique so effective. That’s what this blog is about. If you’re interested in how we think about money, keep reading.

The power of mental accounting

Our first recommendation was to have two bank accounts. The first account is your salary account, which functions as your spending account. The second account becomes your savings account. Why bother with two accounts? Research shows that you are far less likely to spend money labeled “savings”. Even if that label is a purely mental one. Behavioral economists call this phenomenon mental accounting.

Here is what that means. People intuitively think about their money in buckets. It is a simple way to keep track of, and control their expenditure. You may yourself have budgets for different spend categories – transport, going out etc. What is crucial from a savings perspective is that people treat money in different buckets differently. Cash is most likely to be spent. Money in savings accounts is less likely to be spent. The least like to be spent is money earmarked for savings goals like children’s education or retirement. That’s why the simple act of labeling one account as “savings”, makes it less likely that you will spend it.

The evil twins: temptation and inertia

Our second recommendation was to regularly, and automatically transfer your savings from your salary account to your saving account. Two nuances here. First, it is best if this transfer is on the on same day or a few days after you receive your salary. Two, it works better if this transfer is automatic. There are two behavioral issues at play here.

The first is the self-control problem. Even the most organized and well-intentioned of us struggle to control our spending. We build detailed budgets and vow to stick to them. But when the opportunity presents itself, we are unable to resist the temptation to spend. Behavioral experts describe this as if our brain’s decision-making functions are divided into two systems.

They call the first the “Reflective system” or the “Planner”. It is the rational and analytical part that is able to weigh the pros and cons of any decision. The other, which they call the “Doer”, is the emotional, impulsive, intuitive part. When temptation arises, the “Doer” part of our brain often trumps the “Planner”, and our best plans get waylaid (all puns intended). That’s what prevents us from sticking to our diets. When we see those pakoras on a rainy afternoon, it is too much for even the most disciplined to resist. The same goes for spending.

The second is inertia, or what behavioral economists call the “status quo” bias. Basically, people are lazy and they tend to keep doing that they are doing already. That’s the reason why we wait years before cancelling those pesky email subscriptions. Or keep putting off connecting our Aadhaar to our telephone number. Making saving automatic ensures you don’t fall prey to this inertia. And on the flip side, it also ensures you won’t miss spending the money. You will simply adjust your spending pattern. Biases can be a double-edged sword!

Anyway, the point of this article is not just to show you that we’re a well-read team. It is also to show you why the simple act of setting up automatic savings transfers into a separate account is so powerful. It is fueled by basic human intuition and psychology.

READING

Maton, Cicily. (2018). How to Harness Mental Accounting to Instill Good Financial Habits. Interview by Jacob Meade, Wall Street Jornal.

Nelson, E. (2018, May 01). All the human flaws and biases that prevent you from managing money better.

Samuelson, W. & Zeckhauser, R (1988). Status Quo Bias in Decision Making. Journal of Risk and Uncertainty, Vol. 1(1), Pages 7-59

Thaler, Richard H. (1990). “Anomalies: Saving, Fungibility, and Mental Accounts.” Journal of Economic Perspectives, 4 (1) (193-205)

Thaler, R. H. & Shefrin, H. M. (1981). An Economic Theory of Self-Control. Journal of Political Economy, University of Chicago Press. Vol. 89(2), Pages 392-406

Thaler, R. H. (2015). Misbehaving: The making of behavioral economics. W. W. Norton & Company.

Thaler, R. H., & Sunstein, C. R. (2008). Nudge: Improving decisions about health, wealth, and happiness. Yale University Press.

Xiao, Jing Jian & I. Olson, Geraldine. (2009). Mental Accounting and Saving Behavior. Home Economics Research Journal. 22. (92-109)