The always-insightful Jason Zweig of The Wall Street Journal once said that great personal finance journalism is really the art of communicating the same handful of important lessons over and over again without boring people. We’ve been reminded of this maxim recently as we observed the fuss about Black Friday and the decision by some retailers to start the fun early. Because, to our minds, the real holiday shopping blunder isn’t starting to spend too early, but spending the wrong way. And it can hurt you twice over.
We’re referring to a subject we’ve covered before, on this site and in our book: Mental accounting and credit cards. In brief, there’s considerable research to suggest that when people use credit cards instead of (ideally) cash they’re likely to spend more money than they think they will even when they think they’re spending beyond their limits. Here’s what we mean:
Mental accounting is the principle originated by Richard Thaler that explains how we treat money differently depending on any number of factors, including where the dough comes from (tax refund vs. salary) or the size of the transaction (people care more about saving $25 on a $100 purchase than they do on a $1,000 one). There’s also a very good reason to think that when we pay for things in ways that remove us from the idea of actually spending money—i.e. credit cards, debit cards, gift cards and certificates, checks, one-click buttons, tokens and other stand-in currencies—we are less likely to experience the feeling of diminished wealth that we would if we’d pulled cash out of a wallet. In other words, we’re more likely to spend money when it feels less like we are spending money.
This is not news, of course. One of the best features of credit cards is that they let us spend money we don’t have! Everyone knows this. But not everyone understands how using what we might call “distancing currency” (that is, currency that distances us from the idea of spending) can turn consumers into careless bargainers as well as overly enthusiastic spenders. MIT professors Drazen Prelec and Duncan Simester concocted the experiment that shines the best light on this aspect of credit card usage. Back in the day, they organized a sealed-bid auction for tickets to a basketball game. Half the bidders were told that whoever won would have to pay for the tickets with cash (if they didn’t have the money on hand they could pay later), while the other half were informed that the winner would have to pay by credit card. When all the proceedings were done, Prelec and Simester averaged the bids from both groups and discovered something profound: The average credit card bid was roughly twice as large as the average cash bid. In other words, using a credit card not only makes you more willing to spend money you don’t have, it makes you more willing to pay more money for the things you’re buying. It’s not where the term fast and loose comes from, but it might just as well be. Fast to spend, loose with what you’re spending.
Keep that in mind as the holiday shopping season approaches, whenever you decide to hit the stores (real or virtual). Ideally, we’d advise one and all to leave your plastic at home and spend only the cash you have on hand. Barring that unrealistic strategy, we’d advise a two-part compromise: 1) Come up with a total budget for holiday gifts and keep a running tab as you shop; and 2) Before every purchase, ask yourself a simple question: What would I pay for this if I were paying cash?
Neither step will guarantee you won’t spend more than you want to over the next few weeks, but both steps will give you a shot at taming your plastic demons.