Part V in our Wealth Psychology series: Professor Dilip Soman explains why we tend to spend tax refunds and bonuses more lavishly than our regular income — and what you can do now to avoid blowing those cheques when they arrive.
I'm sure you've said it. If only I could win the lottery. I could pay off the house, buy a nice car maybe put some money away for a rainy day. Sounds perfectly reasonable, right? But what if I told you a surprising number of lottery winners end up going bankrupt?
It may have something to do with the way our brains process unexpected or unbudgeted money. Scientists refer to this as windfall gains. And studies have shown that our brains perceive it like free money. We tend to spend more of it, and faster.
Windfall gains don't have to be about winning the lottery or getting a surprise inheritance. The way we perceive something as simple as a raise in our salary or an annual tax refund can feel like a windfall. But that's not free money at all. In the case of a tax refund, it's actually our own hard-earned money. We just let the government hold onto it for a while.
Behavioral economics suggests that we make decisions about our money based on three key factors-- time, money, and context. In this case, our brain processes the idea of money differently based on whether we felt it was earned or unexpected. One thing you can consider to help counter the effects of windfall gains is to establish a plan for any funds you might receive in the future, expected or unexpected. Economists would call this a commitment device.
You could use a simple if/then rule in which you say, for example, if I get a tax return or bonus this year, then I will put 50% of it in a tax-free savings account or an RSP. Studies have shown that just creating a plan for such a windfall can actually make us less likely to blow it.