Tax returns are coming!  Why is it that so many of us blow our returns on junk we don’t need? You know you should be using it to pay down debt, but instead buy all 13 cycles (seasons) of America’s Next Top Model on Blu-ray.

Read on to learn about the tricks our minds play with us when it comes to “found money” and how to overcome them.

The Myth of Fungibility

In order to find out why we waste some of our money, including tax returns, we need to define some financial terms.  The first is what traditional economists call “fungibility”.  Fungibility means that all money, no matter where it comes from, will have the same value to a person.  $50 from work has the same value as $50 from the roulette wheel or $50 from a tax return.  Which makes sense, in a rational world.  All three of the $50 bills should have the same value to us because they can buy the same amount of stuff.

The only problem is that people aren’t rational.  Emotions hold a lot of sway in personal finance.  We make emotional decisions and place different values on our money depending on where it comes from.

This is where the concept of “found money” comes into play.  Found money is basically money that we weren’t expecting which comes to us from sources other than our earned income (work).  For some reason, we tend to place a lower value on found money than on earned income.

The Problem with Found Money

This is why you blow your tax return, because you place a lower value on it than money from a paycheck.  Why does this happen? Why do we place a lower value on found money and end up wasting it?

There is a whole branch of economics (called Behavioral Economics) dedicated to understanding why people behave emotionally when it comes to their finances.  The field of study is relatively new and economists are researching the topic as I write this post.

From what I’ve gathered, it seems that people compartmentalize their money depending on where it came from.  The experts call this “mental accounting”.  We label our money according to its source and thus attach value to it.

The $100 savings bond from Grandma we leave alone to honor her memory.  The $27 won in Vegas we blow on expensive sushi.  The tax return we spend on America’s Next Top Model Blu-rays and rationalize it by telling ourselves “Miss J” will improve our catwalk (I promise I only watch the show for my wife).  It’s clear that when we label our income based on where it came from, it can have negative effects.

Master Your Mind

So how do we overcome the problems of mental accounting and wasting found money?  Here I offer two simple solutions that have worked for me:

1. Consider all of your money as earned income:  Do away with mental accounting! No more compartments for your income based on where it came from.  Just consider any of your income, no matter its source, as a paycheck.  Viewing all of your income in one big bucket called earned income will help you give it all the same value and use it equally.
2. Wait a few days (or weeks): Before spending the money, sleep on it.  This advice is good for all large purchases, but especially for found money because we are more prone to impulse spending.  Since I am prone to impulse spending, my wife institutes the wait policy on me.  Whenever I just have to have something now, she reminds me that I really don’t. A night’s sleep before purchases clears your head and prevents buyer’s remorse.

Hopefully this post has opened your eyes to how much emotions affect our money decisions.  Emotional spending is so important that I wrote about a debt-repayment plan that takes advantage of your feelings.  Now, go use your tax return to pay down debt or invest!

Tags: found money, fungibility, tax return

• Digg
• Stumble it!
• Reddit

• Is Investing in the Stock Market Gambling? An Answer from Tortoise and Hare
• The 3 Things You Must Do Every Time You Get Money
• 5 Personal Finance Writers to Avoid If You Want to Stay Broke and Ignorant