money psychology

Bigger Paycheck or Bigger Tax Refund — Which Should You Pick?

Emily Guy Birken — Tue, 31 Mar 2015 11:00:08 +0000

One of the earliest money lessons that I remember learning from my financial planner father was the correct protocol for tax refunds: The ideal situation is to receive a modest refund of $500 or less. (See also: 12 Smart Ways to Spend $500)

This advice struck a chord because it made perfect sense. Why give Uncle Sam an interest-free loan every year just to feel the excitement of getting your own money back each spring? I agreed with my father that it's a far better idea to keep the money in your paycheck, invest it throughout the year, and let it work for you.

Which prompts the question — why do nearly 80% of taxpayers get a refund each year, at an average size of $2,800?

What financial planning advice often overlooks is the importance of psychology in money matters. For individuals like me, who can think of nothing more fun to do on a Saturday night than balance my checkbook, getting a modest refund really is the ideal situation for managing money. But for many taxpayers, getting a big refund can be the best path to good financial decisions.

How do you know if you would be better off with a big refund or a modest one? Learn more about the psychological quirks could influence your refund decisions.

The Denomination Effect

The denomination effect is a phenomenon wherein people are less likely to spend big bills compared to small ones. If you have ever held onto a $50 or a $100 bill for several weeks, but don't blink an eye at spending the same amount in tens, fives, and singles, then you have experienced this effect.

When it comes to taxes, the denomination effect is why you might not even notice an extra sixty bucks in your weekly paycheck — but turn that into a $3000 refund check at the end of the year, and suddenly it's a large enough amount of money that you feel the need to do something intelligent with it.

If you struggle with keeping track of smaller amounts of money, but feel perfectly comfortable making good decisions with a large check, then it might make sense for you aim for a large refund that you invest. It will be a better use of that three grand than frittering away your extra $60 a week. (See also: 50 Smart Things to Do With Your Tax Refund)

Loss Aversion

This cognitive bias describes people's tendency to strongly prefer avoiding losses over acquiring gains. Loss aversion is a nearly universal behavioral quirk that explains why so many investors hold onto tanking stocks, why would-be exercisers continue sending money each month to a gym they never visit, and why you probably still have a bread machine collecting dust in your basement. We all hate to feel as though we are losing money on something that we have already paid for.

In terms of taxes, the idea of potentially owing the IRS more money come April 15 is off-putting enough to keep many taxpayers from reducing their refunds. Losing money each paycheck to taxes is a given, but the idea of having to write a check to the IRS triggers loss aversion in many taxpayers. They would rather give up the money temporarily throughout the year and overpay Uncle Sam than face the prospect of having to give up "real" money if they get their accounting wrong.

If the thought of having to pay more in taxes than you had withheld from your paychecks puts you in a cold sweat, then aiming for a large refund might be the best option for you. Yes, your money could potentially be doing more for you in your pocket, but what good is maximizing your finances if you sweat bullets thinking about tax time?

The Money Illusion

This term was popularized by the famous economist John Maynard Keynes, and it describes our inability to recognize that a dollar amount is only as good as its purchasing power. Keynes used the term to describe the phenomenon of feeling richer when you receive a raise, even though costs have also risen; meaning you are earning the exact same purchasing power you did before the raise.

When it comes to taxes, the money illusion means that for some people, having a $3,000 refund check burning a hole in their pocket could lead them to make poor financial choices because of the sheer size of the refund.

For instance, if you are feeling flush, you may find yourself spending with impunity in every area of your life, from the expensive chocolate you rarely indulge in, to new shoes that you don't really need. But unless you are keeping careful track of each expenditure (which is the opposite of "spending with impunity"), you will likely reach the end of your big refund amount and keep on spending because you are focused on the dollar amount rather than what it buys. Your mental accounting of your refund money has trouble keeping up with your actual spending.

If you have a tendency to burn through money quickly when you have a big windfall, then it's probably a good idea to aim for a modest tax return — and set up a direct deposit of the saved money into an investment, retirement, or savings account. That way, you can make the intelligent decisions about your money before you are faced with an amount that will trigger the money illusion.

Don't Discount Your Money Psychology

We tend to think of money as a purely rational issue, but it's foolish to ignore the fact that how you feel about money will influence your financial decisions, for better or worse. In a purely rational world, receiving a large refund check every April does not make any sense. But depending on your personal money makeup, you might find that a large refund is your ideal, or you might find that keeping more of your cash in each paycheck works best for you.

The important thing is to be mindful when you make decisions about money, and to take your psychology and your strengths and weaknesses into account. Know yourself, and your finances will thank you.

Are you getting a big refund? Why or why not?

This article is from Emily Guy Birken of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Your Money Problems: Why They're All Your Fault

Tara Struyk — Tue, 14 Aug 2012 10:24:41 +0000

I love writing about money — not because I’m obsessed with wealth (or my relative lack thereof), but because I think the way we spend our money reflects who we are, good or bad. That’s probably why I bought the very first condo I saw. I’m known to be impatient, impulsive even, in just about all things.

Was it a mistake? So far so good, but I left a lot more to fate than is probably wise in a six-figure purchase. And let’s just say that I hope to exercise a little more self control next time. Of course, whether it’ll actually work out that way is another story altogether.

But that’s really what issues that surround money are all about, isn’t it? The way we behave with our money is a lot like many other things in life — we know what we should do, but that hardly means we actually do it. We know we should exercise, avoid fast food, and eat more vegetables just like we know we should spend less, avoid debt, and save more of our money. Most of us struggle with both, at least sometimes. The key to solving money problems, then, often isn’t about outside factors (like making more money). Instead, it’s about our own habits and behaviors. (See also: Party Like It's $19.99: The Psychology of Pricing)

So how can we make better choices when it comes to money? First, I think, we need to accept that our money problems are (usually) all our own fault. Then, it’s time to stop relying on self discipline and develop habits that put bad choices out of reach.

What’s the Problem?

I think the key to unraveling any money problem is to first accept that the problem is probably an emotional one. Just think about some of the money problems people tend to get into. Debt is one of the most obvious, and if you’ve ever watched Suze Orman or Dave Ramsay or Oprah address this, it’s pretty clear that debt goes much deeper than just a frivolous desire to acquire more. For some people, a desire to give their kids all the things they never had growing up makes it impossible for them to say “no.” For others, a financial setback has them feeling too ashamed to admit they can no longer afford the lifestyle they’re used to. And far too many people feel important, triumphant — even happy — when they come home from the mall with an armload of new purchases — whether they can afford them or not.

Anyone can see that those things aren’t really about money, which is why all the money in the world is likely to lead these people down the exact same path. That may be why so many lottery winners end up penniless in a few years. They throw their money everywhere, because what they’re looking for is something money can’t really buy. The problem is that while we all fall prey to emotion-driven money behavior from time to time, few of us are aware of it.

Who’s to Blame?

Let me just start by saying that not all money problems are the result of emotional issues. People lose their jobs, rack up huge medical bills, or fall victim to some other financial pitfall that’s beyond their control. I get that. But what I also know is that a whole lot more people make excuses for themselves and blame their problems on things that are outside of their control rather than face the fact that they themselves are the real problem. I know this because not only have I seen a lot of people do it, but because I also have a tendency to do it myself. And even though I wish I knew better, I often have to remind myself that the big credit card bill isn’t my car’s fault — it’s mine for not setting some money aside; that when I choose time over money, the smaller check I receive is no one’s fault but my own; that when I balk that I can’t afford something that’s really important to me, I’m really just playing the victim rather than doing the hard work required to make it happen.

You see what I’m getting at here, right? Your money — and all the issues that come with it — are your problem. Admit that, and making better choices will be easier. After all, it’ll be a lot harder to ignore what are really just consequences of your own bad choices when you have no one else to blame.

OK...Now What?

Even if you know you make bad choices when it comes to your money, making better ones is always hard. That’s why I think it’s best to leave as little to choice as possible. Several recent studies on decision-making have indicated the existence of something called “decision fatigue.” In essence, researchers believe that decision-making and willpower may come from the same mental store. When we are overburdened with decisions, our decision-making suffers — and so does our willpower. This is why so many people make poor spending choices at the end of a long and stressful day at work, or grab a few impulse buys on their way out of the grocery store. (Hence all the junk food right beside the till.)

When it comes to your money, then, it’s best not to leave everything to choice. Don’t choose to spend less — leave only enough in your checking account for planned expenses. Don’t choose to not use your credit cards — cut them up or lock them away so that you can’t pull them out in a moment of weakness. Don’t choose to save a portion of your paycheck — have it withdrawn from your account automatically. In other words, rather than making better decisions, try to make fewer decisions. That way, you’ll be able to save up your self discipline for when a tough choice really is required — and hopefully make a better one.

A Tangled Web

If you struggle with money problems, you probably already know that it’s a complicated issue. But next time you catch yourself doing something with your money that you know you shouldn’t, stop and ask yourself why you’re doing it. You might be surprised by the answer, but in many cases you’ll be most surprised to learn that it’s not your money that’s the problem — it’s you. Once you get that messy business out of the way, you’ll be far better prepared to do something about it.

And don’t just do it for money, either. Do it for you. If the way you manage your money is a reflection of you, the effects of better habits are likely to spread far beyond your bank account. You may never be rich, but that’s quite a payoff.

This article is from Tara Struyk of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

The Psychology of Free, and Its Power Over You

Paul Michael — Mon, 12 Dec 2011 11:24:23 +0000

I was told in college, and in most ad agencies I’ve ever worked in, that two of the most powerful words available to any advertiser are FREE and NEW. Of course, over the years, the word free has been abused and perverted by advertising jargon and now comes in many forms, including:

Free* (The * is a list of conditions that most people never read but wish they had.)
Free Trial (Sometimes it’s genuine; sometimes you get sucked into some nasty monthly payment.)
Risk-Free (This one’s just odd; it implies that there may actually be a risk.)
BOGO (buy one, get one) Free (Genuine enough, although lately it’s become BOGO half-off.)
Free and Clear (Often used in conjunction with buying large products.)

However, despite the various incarnations of free, it remains an incredibly powerful word, and its influence over us as consumers is magnetic. Who doesn’t want free stuff? But how, where, and why "free" is used is all part of an equation that can either draw you in or push you away. (See also: Advertising Jargon That Aims to Mislead)

Genuinely Free Deals Are Irresistible — If There’s a Good Reason

People love free, but they are clearly skeptical of it. They want to feel like they've earned the item, or that there's another good reason for it to be free.

If something really is free and there's a good reason for it, consumers love it. Free samples of food in the aisles of grocery stores always go like wildfire. People know they get a free sample to lure them into buying a full box or package. That’s a fair exchange.

If someone puts a fridge on Craiglist for free (more on that later) because they want it gone ASAP to make space for a new fridge, then that’s fair. There’s a good reason for the giveaway.

If you get free products for spending a certain amount of money, that’s acceptable. Spend $75 and get a free tote or bottle or perfume. Yes, that's a good deal. The thought is, “I spent more than I wanted to, so I get a reward.” That’s why genuine BOGO offers are so big.

The Reverse Psychology of Free

As much as we love the idea of free, we're also suspicious of its value. The following story may be an urban legend, but even if it is, it proves a good point.

A man had just purchased a new refrigerator for his home, and did not want to go to the hassle of selling his old fridge or hauling it away. So he put a sign on it saying “FREE to Good Home” and left it on the curb.

It sat there for days. No one wanted it. So, he put another sign on it saying “Fridge For Sale, $50.”

The same fridge that no one paid attention to was stolen within a day.

This is the reverse problem with free. Either people don’t trust it, or it diminishes the value of something to worthlessness. There’s this attitude of “why is it free; what’s wrong with it?” In the case of the fridge, people clearly thought it was a broken, old, or unusable object, otherwise it would have had a value. By attaching a value to the fridge, that problem was alleviated, and it was stolen.

Overall, Free Ain’t What It Used to Be, but It’s Still Great

Sadly, marketing and advertising firms have stripped a lot of the meaning away from free. It’s a shame, because when companies really do want to give away free products to increase awareness, they have a hurdle to jump over. But there are amazing free deals out there every day, you just have to keep your eyes open and remember to ask the right questions — Why is it free? What’s in it for them? What’s in it for me? Is there a hidden catch? Is it really free at all?

This article is from Paul Michael of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

The Psychology of Cash Flow

Philip Brewer — Mon, 14 Nov 2011 09:48:32 +0000

Money flows into your life, and money flows out. To deal, you need to get your finances right — but also your mind. (See also: Managing Your Short-Term Money)

Are your finances under control? One good test is how your spending is constrained by your income.

Far too many people are forced to arrange their bill paying around their income schedule. They put bills aside until their paychecks arrive, then they write the checks (or authorize payments online), hoping they don't run out of money before they run out of bills.

If your finances are under control, there's no need to do that. You always have enough money to pay your bills, whether "payday" is today or tomorrow or next week.

Control Your Finances

You only need two things to get your finances under control:

You need to have an income that's larger than your expenses.
You need to have "enough" money sitting in your checking account.

In this case, "enough" is a reasonably specific amount — enough to pay the largest sum of bills that can be expected to arrive between two paychecks. For most people, one month's expenses is a handy target. There are, of course, special circumstances, such as annual or semi-annual bills for car insurance or property taxes. You could just leave enough money in your checking account for those, but they're probably better handled by accumulating money in some sort of savings or investment account.

If those two measures aren't in place, you need to take action right away. Perhaps emergency belt tightening is in order to get your expenses below your income, and then to accumulate the appropriate cash balance in your checking account. But even once you've got those measures in place, getting this right is tough, because this isn't just a matter of getting your finances under control. You also need to get your mind under control.

Case in point — me.

Not having a regular job, I get my income from various sources — interest, dividends, payments for my stories or articles, and so on.

One of my regular payments used to arrive late in the month, but a while back things got rearranged, and it started arriving early in the month.

This turned out to have an unexpected psychological impact.

Here's the thing — the payment used to arrive shortly before we'd make the monthly transfer into our checking account to cover that month's expenses. Now, the payment arrives half a month away.

Before, it felt like my writing income was paying a big chunk of the bills, and then we'd transfer money to cover the various small expenses that show up over the course of the rest of the month. Now, it feels like we're drawing down capital to pay our bills, while my writing income ends up dribbling away to pay those ancillary expenses.

The reality of the situation hasn't changed at all. The right way — the smart way, the useful way — to think of the situation is to view all the money that flows into my life as my money. I've written about this before — it's all your money.

Control Your Mind

It's hard to defeat the notion that the dates that the money flows in and out make a difference. But even though it's hard, it's worth doing.

Getting this right is key to financial success.

Get your finances under control. Your spending should be controlled by your budget, not by when your paycheck arrives. See past the illusion that money that arrives one day has anything to do with the money that gets spent the next.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Party Like It's 19.99: The Psychology of Pricing

Julie Rains — Thu, 21 Apr 2011 10:24:09 +0000

Why does everything on sale — well, nearly everything for sale and not simply "on sale" — have a .99 price ending?

From what I can tell, .99 is a signal to consumers that either means "Wow, this widget is a great bargain," or "Whoa, you're manipulating me into thinking that this widget is a great bargain." (See also: What Clearance Price Is Your Achilles Heel?)

I did some poking around to see why prices tend to end in 9s and .99s — and what retailers are trying to communicate to consumers when prices end with other numbers as well.

The Rationale for $19.99 and Similar Endings in 9

The use of "9" sends a signal that an item is a great value and possibly the lowest price available. Sale prices end in 9s and .99 so often that shoppers associate these numbers with a markdown even when the starting price contains a 9.

Consumers tend to place more emphasis on left digits than right ones (also known as the left-digit effect). And they "ignore the least significant digits rather than do the proper rounding." I like to think that I round $19.99 up to $20.00 rather than mentally truncating the last two digits to $19.00, but research suggests that most people retain the first two numbers only, possibly because people have gotten used to .99 as a price ending.

The .99 ending seems to be a default pricing strategy. Retailers intentionally price items as $X.99 to send the message that an item is a great buy and has been recently marked down. Or they simply don't put much thought into pricing and end all prices with .99 to match pricing schemes of most competitors.

In situations where items can be sorted by price, such as e-commerce and real estate databases, using $.99 or $399,999, for example, allows the seller to keep an item in certain price bands or break points unavailable to those charging $1.00 or $400,000 for similar items. (See "The Psychology of Pricing" relating to real estate from The New York Times.)

The Meaning of 0 and .00

Sellers use 0s and .00 to convey that products are of premium quality.

From the buyer's perspective, these prices seem arbitrary, not reflecting cost but rather the seller's preference. Actually, that is the message intended by those selling luxury and high-end brands. A designer handbag at Neiman Marcus is priced at $625.00, not $624.99; similarly, Godiva sells its chocolate truffle assortment for $36.00, not $35.99. The seller can, theoretically, name a price rather than be subject to clamor by consumers for lower pricing.

Some mid-range retailers also use .00 for standard pricing (J.C. Penney and L.L. Bean for example) and .99 for sale pricing. Still others use .00 for higher-end product lines but retain fractional pricing (e.g., .99 or .97) for value product lines. (See Psychology of Pricing from Happen.)

The exceptions to this premium-quality rule are the many "dollar" stores.

The Differentiating Power of 4 and 7

Unusual prices ending in 4s or 7s tend to be seen as precisely priced items. The signal is that the seller has scrutinized its costs and determined the optimal price, fair to both the seller and buyer.

Certain companies may also use non-standard pricing (that is, avoiding the use of 9s and 0s) just to be different. Lowe's and The Home Depot sell certain items for $1.74 or $294 rather than $1.99 or $299.

Pricing that ends in anything besides a "9" (not just 4 and 7) typically stands out to the buyer. Some sellers adopt certain endings as a signature pricing signal. Walmart, for example, ends many of its prices in 8, positioning itself as just a tad less expensive than retailers that price items ending in 9.

Tips for Consumers

Recognize that numbers speak to your subconscious and have meaning based on previous shopping experiences and retailers' wiles. Compare prices to make sure you are getting a bargain. Don't assume that anything priced at $19.99 is a great deal.

This article is from Julie Rains of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: