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Unfungible People

The link between emotions and decision making, particularly financial decision making, has been recognized for years.  This is a tricky area because the connection between emotions and rationality is difficult to unpick, which is why making investment decisions while in an emotional state is usually not recommended.

To complicate matters, though, it now appears that we associate certain types of money with certain types of emotion, and will only spend such money on certain things.  Which is odd, because the last time I looked money doesn’t seem to be especially emotional: it rarely breaks down and starts sobbing when you try and spend it.  Money is fungible, but people aren’t.

Give Me Back My Lawnmower

Fungibility is one of the key attributes of money: it basically means that one dollar is indistinguishable from another – you can turn money into anything money can buy – bread, kippers, thermonuclear weapons, boob jobs, whatever.  One ten dollar note is as good as another one, but if I lend you a lawnmower and you give me back a pair of garden shears I’ll not be happy: gardening equipment isn’t fungible.

Fungibility is a core assumption of financial theories and is obviously correct in a technical sense.  Unfortunately being technically correct isn’t something that bothers most individuals, who operate on the basis of personal psychology rather than the theory of money.  Emotions loom large in much financial behavior.  Arguments over the usefulness of emotions have raged over centuries.  The Ancient Greek Stoics believed that they were useless appendages to the human condition, which needed to be ruthlessly suppressed – a view which many philosophers and economists have shared down the years.

Immoral Money

A more nuanced view has argued that emotions are actually evolutionary adaptations which allow us to make rapid decisions in changing circumstances.  As such emotions are more mindful than simple reflexes, and are adaptable as our environment changes; but they’re not really thinking in the sense that we normally mean.  Nonetheless, emotions interact with cognitive processes, and will tend to bias us in certain directions.

One of these directions, it turns out, is to do with the way in which we spend our money.  In Feeling Immoral About Money: How Moral Emotions Influence Spending Decisions the researchers show that if we feel guilty about receiving money – perhaps because we’ve lied to get it – we’ll tend to spend it in “pro-social” ways  that benefit others – by donating to charities, for instance.  However, this only applies to the “dirty money”, and not to other funds.  We effectively segregate the tainted cash.  As the researchers state:

“The specificity of this compensation process suggests that people who feel guilty about money aim to cleanse the tainted money rather than seek to redeem themselves and restore their general moral standing. Moreover, this attempt at cleansing the money may indeed be effective as deciding to spend the money on charity reduced participants’ feelings of immorality and guilt associated with the money”

Even better, if the emotion associated with the money was anger rather than guilt we decrease our spending on charities – and on other people.  So if, for example, someone receives a smaller bonus than they think they deserve, then their response to receiving the money is not pleasure or gratitude, but anger and resentment.

Mental Accounting

The idea that we tag certain money with emotions is similar to another behavioral effect we’ve previously witnessed – the idea of mental accounting, where investors assign money to different pots and then treat them completely independently (see: Mental Accounting: Not All Money Is Equal).  Indeed, this has been used to provide a behavioral treatment of why people buy insurance and lottery tickets – the behavioral portfolio idea of Hersh Shefrin and Meir Statman, where people have downside, low risk investments and upside, high risk ones and don’t like seeing securities move between them; which is maybe why investors don’t like dividend cuts. (see: Behavioral Portfolios).

Jonathan Levav and Peter McGraw have developed the ideas of emotionally tagged money and mental accounting into a theory of moral accounting, wherein the circumstances under which money is received determine the way in which it’s consumed.  In Emotional Accounting: How Feelings About Money Influence Consumer Choice they argue that people will tend to avoid spending negatively charged money on luxuries such as a holiday and are more likely to attempt to “launder” the money by spending it on something virtuous, such as education.

Moral Accounting

When Luc Christiaensen and Lei Pan looked at how this impacted fungibility in On the Fungibility of Income - Spendings and Earnings in Rural China and Tanzania, they observed:

“The results suggest that people are more likely to spend unearned income on clothing, alcohol and tobacco, transportation and communication, as well as gifts, while they are somewhat more likely to spend earned income on staple foods and invest it in education.”

Or, roughly, the harder people have to work for their money the less likely they are to spend it on so-called hedonic goods, and the more likely it is that it’ll be used for virtuous or necessary spending.  It’s perhaps not surprising then that the way financial windfalls are framed determines how they’re spent.  Nicolas Epley and Ayelet Gneezy in The Framing of Financial Windfalls and Implications for Public Policy found:

“Governments, employers, and companies provide financial windfalls to individuals with some regularity. Recent evidence suggests the framing (or description) of these windfalls can dramatically influence their consumption. In particular, objectively identical income described as a positive departure from the status quo (e.g., as a bonus) is more readily spent than income described as a return to the status quo (e.g., as a rebate).”

Hard Work, Careful Investing

So, money perceived as easily earned is more impulsively spent than money which is come by through hard work.  There’s no research on this as regarding investors, at least that I can find, but it suggests that people who look to trade for short-term profits rather than long-term gain are more likely to invest in speculative enterprises.  Certainly day traders rapidly become more confident and start placing riskier bets, as Juhani Linnainmaa relates in The Anatomy of Day Traders:

“Conditional on remaining in the market, day traders become more confident and aggressive as their careers progress; they more often sell stocks that they do not own, trade in larger sizes, and become more highly leveraged. The decision to try day trading again after successful first day trade resembles the behavior of problem gamblers.”

Hardly conclusive, but interesting nonetheless.  Putting emotional tags on specific pots of money and framing them in terms of being hard earned or windfall profits will likely influence the way we choose to spend that money.  How many investors sell half a holding when it’s doubled and then take a “free ride”?  That’s not a windfall, it’s fungible investment cash which should be treated with due respect.

One-Eyed People

It is, of course, fundamentally hard to strip emotion away from the source of money, but the evidence strongly suggests that we need to do so.  Money is money is money.  It’s all fungible and a behaviorally educated person will put their emotions to one side when deciding how to spend it.

It’s no coincidence that the only people who behave like economists say they should are people trained in economics (see: Studying Economics Makes You Mean).  Whilst I wouldn’t wish that on anyone, we’ll all allocate our cash better if we’re trained in behavioral economics.  Always remember that in the land of the blind the one-eyed man is King.

This article originally appeared at The Psy-Fi Blog . Copyright 2014.