Most people seek out financial advice for the meaty tips, like advice on how they should allocate their portfolio among different asset classes, and which stocks to buy.
Increasingly, though, money gurus as esteemed as our nation’s consumer finance watchdog, Elizabeth Warren, are speaking on the ideal form of our finances, as much as they are on the substance.
That ideal? Simple. Simple finances are much more likely to be smart finances. The more complicated our financial obligations, the less likely we are to understand them and manage them well.
This jives with an inherent human preference of simplicity when it comes to money matters, as described by Meir Statman in his latest book, "What Investors Really Want: Discover What Drives Investor Behavior and Make Smarter Financial Decisions."
Statman says one strategy we humans leverage to create the financial simplicity we crave (or the illusion of it, anyway) is mental accounting, a mind game in which we "place monies in distinctly labeled ‘mental accounts’ and treat them accordingly."
And pretty much everybody, everywhere, does this. Statman points out that Norwegian sex workers mentally deposit their welfare funds in "straight-life" accounts they use to pay their rent, and their "trick money" into mental accounts allocated to (and quickly spent on) drugs and alcohol.
He quotes a Philadelphia gang member who refused to put the proceeds of his thievery into the church offering, because "that is bad money; that is not honest money."
Even with so-called normal people, we use mental accounting as a means to control ourselves. We spend windfalls, lottery winnings and even the earnings on investments much more freely and with less compunction than money we worked for and saved up.
I believe that this mental strategy, which seems sensible in many cases, times millions of homeowners who practiced it during an era of rapidly inflating home values, contributed in no small part to the foreclosure crisis we’re still reeling from at this very moment.
That seemingly endless, sourceless home equity which was accruing in homeowners’ accounts — mental and otherwise — seemed like a windfall; fast, easy money that could be spent without compunction.
Add to that the context of bizarrely easy mortgage lending, with lenders literally mailing you offers for cash against equity you didn’t even know you had, and you can see how it became completely commonplace to do a cash-out refi or take a home equity line or loan and, well, get to spending. Easy money, easy spending.
Until the seemingly endless rise in equity did, in fact, end. The flaws in the logic behind the easy-money mental accounting of the subprime era quickly became apparent.
People realized that the home equity they’d spent wasn’t actually easy cash — and what they had spent wasn’t actually theirs — it was debt secured by easy value. And that meant, when the easily gained value went away, the debt did not.
On the other hand, the money required to pay the debt was very real, hard-earned money. The same money that many who had borrowed against the then-easy-now-gone equity no longer even had the opportunity to earn, because their jobs had disappeared.
Add to that the context of very, very tight mortgage lending guidelines, and you see how the mental accounting that some use as a proxy for self-control actually got hundreds of thousands of Americans stuck in upside down homes, or resulted in them losing their homes entirely.
Now, the mental accounting we American homeowners do is different. It’s not so much that easy money gets spent and hard money gets saved, even in areas where home values are on the rise.
Homeowners who have equity don’t see it as easy money anymore, even though they didn’t have to work for it. They see their home equity as part and parcel of their home itself, the asset, and the place where they live. They see it as untouchable. It’s their most precious asset. No, seriously.
And many won’t do anything — not borrow, nor spend — to further burden it, to subject it to the risk of loss.
Even the cash they earn, in this new mental accounting, is to be spent more easily than cash borrowed against their home. In the final analysis, the recession has not only revised our actual accounts, it has revised our mental ones, as well.