Saving money can be tricky. Sure, we’d all like to set aside money with every paycheck, happily watching as our savings accounts grow, but this is easier said then done. Luckily, there is good news and better news about this. The good news is we’re not entirely to blame when it comes to our less-than-stellar savings habits—our brains are designed to be good at many things, but saving money isn’t really one of them. The better news is that by understanding how are brains do work, we can get around the obstacles between us and smart saving.
The Endowment Effect: It’s Mine, ALL MINE!!!
“Endowment effect” is a term coined in 1980 by Richard Thaler, economist extraordinaire and pioneer of behavioral economics, a field created to solve a pretty big problem with classical economics: while classical economics has a lot to say about how markets ideally should behave, it doesn’t do a very good job of predicting how human beings actually will behave. By applying insights from psychology (how we think), behavioral economists explain and try to predict what actual humans will do in any given situation.
The endowment effect describes the curious fact that people tend to value things that they own more highly than things they don’t. Once we feel like something is “ours” we form a strong attachment to it, beyond any rational appreciation of its actual value. Basically, we all become Gollum from Lord of the Rings, skulking in the shadows while protecting our “precious” at all costs.
In a series of experiments, Thaler and his colleagues showed that the endowment effect affects us even with things we wouldn’t usually value very highly, and even if we’ve only owned them for a very short time. In one experiment, college students were divided randomly into three groups. The students in the first group were given new coffee mugs. Students in the second group were given money and told they could buy the mugs from the first group. Finally, the third group of students were allowed to choose between receiving a mug or some amount of money.
The experiment found that while the second and third groups of students quickly formed a consensus on how much the mugs were worth (about three dollars), the first group of students thought their mugs were worth more than twice as much. In the very short time that the first group had “owned” their mugs, they came to value them more than twice as highly!
The endowment effect pops up a lot in human behavior, including when it comes to saving money. We “own” the money that we have, it is “ours,” and as long as it is in our wallet or our checking account, we feel like we can get to it whenever we want. But as soon as we put it in a savings account, giving up that immediate ability to spend money feels like a loss, even though rationally we know that it’s not.
Luckily, once we understand it, it doesn’t take much effort to get around the endowment effect, as long as we follow a few easy steps: Save often, save a little, and save without thinking about it.
Save often. Making saving routine has a couple of benefits. First, by saving continually, it becomes “normal” and our brains stop thinking that putting money away for later is the same as losing it.
Second, saving often (daily, if possible) is like eating a steady, healthy diet instead of crashing back and forth between binge eating and crazy diets: by modifying our habits healthily and sustainably, we never get to a place where we feel the need to take extreme measures (e.g.. “Oh my gosh, I better put THIS ENTIRE PAYCHECK in my savings account!”) which often result in backsliding and defeat. It’s much better to:
Save a little. Because you are saving often, you only need to save a little at a time, minimizing the endowment effect. This is the same reason that panhandlers usually ask for “spare change”: they know that people might be willing to part with so little, but would be a lot less likely to hand over five dollars. By saving the equivalent of “spare change” frequently, it never feels like a big deal, but can soon add up to a whole lot.
Save without thinking about it. Finally, the best weapon against the endowment effect: automatic saving. By deciding to enroll in a savings program that transfers money into your savings account automatically, you completely avoid the feeling of losing something. Because the savings are automatic, you don’t have the stress of actively making the decision every time you want to save: saving becomes the default setting.
By following the above steps, you can defeat that annoying endowment effect, and at the end of the month…there is a bunch of “new” money in your savings account! It feels like somebody gave you a present!
Which they kind of did, only that somebody was you, by choosing to be smart with your money.
And that is something worth celebrating.