Any sum of money is relative — $5 compared to $10 is pretty big (50%), while $5 compared to $1,000 is pretty small (0.5%). And this relativity is important because when it comes to financial matters, we are often unware that it exists, leading us to bleed more money than we think we do. Gary Belsky and Thomas Gilovich illustrate this fact in their book Why Smart People Make Big Money Mistakes (as quoted by G. Scott Budge in The New Financial Advisor).
The authors (Belsky and Gilovich) ask the reader to review these two scenarios:
Scenario 1: Imagine that you go to a store to buy a lamp, which sells for $100. At the store you discover that the lamp is on sale for $75 at a branch of the store five blocks away. Do you go to the other branch to get the lower price?
Scenario 2: Now imagine that you go to the same store to buy a dining room set, which sells for $1,775. At the store you discover that you can buy the sme table and chairs for $1,750 at a branch of the store five blocks away. Do you go to the other branch to get the lower price?
According to Budge,
Time and again, the research shows that more people will go to the other branch in the first case but not the second. The same amount of money at stake, but the relative size of the transaction creates a different sensibility in the consumer. This translates to a problem financial planners see all the time: people don’t make their savings objectives because it is often in the small transactions of a meal out here or a DVD bought there that the budget is blown.
What I find even more interesting is a real-life case study Budge cites. In the case, a couple separated the financial duties of the family as follows: the husband earned the money, and the wife handled it (such as budgeting and paying the bills). As the husband earned quite a significant amount of money, he could not understand why his wife would feel so strongly about his purchase of small-ticket items like shirts, meals out, and the like. It was only after his wife sat him down and made him see how all the small sums added up that he realised what he thought was insignificant spending was actually much more than what he had thought it was.
There are a couple of issues in this case:
- The “insignificant” spending of the husband were small compared to the amount of money he was bringing into the family; however, it was insignificant only when each bill was considered by itself. When added up together, the “insignificant” spending was no longer insignificant.
- By giving the responsibilities of budgeting and bill-paying to his wife, the husband was able to shelter himself from the mental realities of his spending.
These two issues were addressed by the couple having a monthly budget meeting, where the wife would update the husband on how much was spent and on what it was spent on.
The idea of the relativity of money reminds me of the “latte factor”, a term coined by David Bach in this book The Automatic Millionaire. It refers to how people can spend $5 to $10 everyday for a cup or two of latte from Starbucks without realising what it is costing them in the long run (approximately $1,000 to $2,000 a year). One of the basic ideas behind becoming an “automatic millionaire” is that by eliminating these habitual cash outflows, you can actually quite considerably increase the amount of money going into savings and investments, which could well be the difference between your retiring as a millionaire or not.