Easing Our Financial Minds
Introduction
Do you look forward to payday?
Without the Payday Effect
A scenario:
It’s Tuesday at 2:00 and Timmy is walking down Main St. He’s got to pick up his daughter from daycare in about 45 minutes to get her to swim class by 3:30 and he absolutely has to get gas. As Timmy goes through how much time he has to walk to the car, drive to daycare and grab the kid, then drive to the gas station and pump gas, then get to swim class, he realizes that he actually has some extra time.
“This is fantastic!” He thinks. “I never have extra time anymore!”
Now, choices need to be made. Does Timmy stroll around for a while? Get coffee? Check out what exciting things are happening downtown? He knows a couple of shop owners so he could stop in and just say hello and have a brief chat if he chose.
Payday is Thursday-two days away- and Timmy’s only got $20 left in his pocket.
Well, he knows that he has to get gas, so maybe he should save the 20 for that, since $20 of gas won’t even come close to filling the tank. But it is almost payday, and he does have some time to kill.
Timmy decides at once that he should grab a coffee, then visit a friend in a shop. The money left over will get him plenty of gas to get to swimming and then he’ll fill up the tank in a few days after he gets his paycheck. Along the way he sees a sale at the shoe store, but even though he’s training for a race, he hardly thinks about checking the shoes out. Not worth it. The shoes he owns still have plenty of miles left in them.
Perfect!
Timmy used opportunity cost to weigh the effects of his spending and came up with a solution that felt right to him.
But what if Timmy had only had $10 in his pocket? What different choices would he have made?
Obviously, using the same idea of opportunity cost, he would have decided that getting his daughter to swimming without the possibility of running out of gas would be far more responsible than getting coffee and putting in only a gallon or two of gas. As for the shoe sale? It doesn’t really register in the mind of a guy in possession of only $10, who, as stated, doesn’t actually need new shoes.
Again: Perfect!
With the Payday Effect
Now, what if this had been a few days later- just after payday?
The Payday Effect means things could turn out much differently.
“Wow!” Timmy thinks, “I’ve got so much time and so much money. And, Holy crap! There’s a sale at the shoe store! What a wonderful coincidence- I just started training for a road race and right now I really want new running shoes!”
Timmy walks out with some really nice, top-of-the-line running shoes, grabs a coffee and heads off to get his kid. $298 poorer.
Terrible.
The Payday Effect means that people tend to spend more just after they receive a lump sum of money, then moderate themselves until the next sum comes in. (Interestingly- or perhaps alarmingly- mortality also rises just after payday.) So, Timmy makes choices based on a combination of how much money he has and what his different priorities are. As we can see, those priorities can be quite flexible.
British Naval Historian Northcote Parkinson looked out at the diminishing British empire and saw that the number of administrators instead of also diminishing, actually continued to grow. He famously realized that, “Work expands so as to fill the time available for its completion.” Put another way: we have an amazing capacity for wasting our time. Think about the hour and a half meeting where you walk out and realize that what you learned could have been stated in about three or four sentences.
But I believe we do this throughout our lives.
In a way, the Payday Effect is just another form of this. Our perception of what we can spend changes based on what we have. In the news recently was the startling fact that 58% of Americans live paycheck to paycheck. Even more startling, however, was that 30% of people earning $250,000 or more were doing the same. $250,000 and living paycheck to paycheck! If you earn that amount of money, you are in the top 5% of all earners in the country. Top 5% and living paycheck to paycheck!
Clearly what we perceive as “needs” is quite flexible!
Income Smoothing
Clearly, many of us are hardwired for waste. And if we are being honest with ourselves, we all probably know that. We seem to be governed by a Financial-Parkinson’ Law; the ability to expand our finances to the amount of money we have right now. It is the food that we throw away; it’s the clothing we never wear; it’s the mindless calories that we consume; and the list can go on and on.
But I don’t want us to feel badly about this. The point is to live in such a way that we don’t have to feel badly. In fact, in many instances we already set ourselves up to automatically put our minds at ease: We make shopping lists to try to cut down on food waste; those who feel recycling is important set up a system to make it easy to do so; when possible, we develop a system to get everyone in the household up and out the door with the least resistance possible (I italicize possible because kids/spouses are not always on the same page!). These are all instances where we could waste our time and energy- not to mention our mental space- but try to set up a system to make things more efficient.
What I propose, is that we do that with our money.
Financial constraint is really only possible over the long term when we make it easy to be so. Holding onto several hundred dollars and not wasting a good part of it is not possible for most of us! Is it possible for some? Yes, of course! In the same way that some people quit a habit like smoking cold turkey in one try, while others, like me, tried to quite several times a year for decades before it finally took hold.
Income Smoothing means that we make sure all percentages of our income that need to go to certain things automatically go there, or into a dedicated account. It means that our money for “waste” is accounted for, thus making it “impulse” or “pleasure” instead of “waste”. But we must accept these constrains ahead of time. It is not wasteful if it was put aside for that dedicate purpose. And we then have a natural braking system that works with our other natural tendency for using opportunity cost when we have these constraints. That is, we can notice the shoes, then weigh whether it is really worth it to get them, but not succumb to impulses just because we happen to have a lump sum of money, parts of which should be put to other purposes.
New scenario:
Timmy has to pick up the kid and get gas before swimming but has some time. He decides to get a cup of coffee, then go see a friend or two. He notices a sale at the shoe store- he is planning for a race, after all- and says to himself, “My shoes are great, but before the race I may need some new ones. If I do, I’ll plan to save a bit of my “fun money” and get them. While I do love a sale, I’m not gonna fall for it- there will be plenty of sales between now and the race!”
Outstanding! He never even thought about payday.
Final Test
A test for whether you should reconsider the way you plan your finances:
Do you look forward to payday?
CVW Financial, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
