The situation arises with a large inheritance from a relative, bonus at work, lottery win or, like me, finding a small amount on the street.
Windfalls are a nice and welcome surprise; however, how we spend these fortunes (and how they influence the rest of our budget) can also be surprising.
Standard economics says…
Standard economic theories of how we spend and save money assume that people take a long-term view and base their saving and spending decisions on their expected income and expenditure over their entire life. Examples of these theories include the lifecycle and the permanent income models.
But research about windfalls – unexpected gains that are likely to only happen rarely – show that this isn’t the case, and, interestingly, whether the windfall is small or large affects how we spend it.
When we budget, we often fudge it
Small windfalls, such as a coupon or voucher, tax return or winning an office sweepstake, should in theory have no effect on spending. The amount is so small when considered against lifetime income that it is effectively negligible: €1,000 over the course of 60 years doesn’t make a substantial change to a day-to-day budget. But academics Katherine Milkman and John Beshears find that even a windfall of $10 does indeed change spending, with people purchasing items that they wouldn’t usually buy.
The researchers suggest that the reason why we spend windfalls differently to other forms of income is due to mental accounting. Explained in detail here, mental accounting is our tendency to think about income and spending as belonging to certain categories, or “accounts”. Although money is fungible (one euro is the same as another and can be treated as such), in reality many people don’t treat it that way.
Money received as a birthday gift might be mentally earmarked for “entertainment” or “treat”. Similarly, income from a rental property, stock dividends, or from taking on extra work might be treated differently to the salary earned from a day job. Although a small windfall may not seem like much in the context of a lifetime, in a narrow mental account of “weekly groceries” or “back-to-school clothes shopping” even a small windfall can feel like a meaningful increase in wealth, and thus change spending behaviour.
The windfall might even feel like “free money” and be allocated to a mental account of its own.
That “payback” feeling
Other potential explanations for windfall spending patterns are reciprocity and happiness. Recipients of a windfall may feel subtly indebted to the source of the money (such as the store providing a voucher, or the casino paying out the winnings), so may spend their money back with the benefactor to reciprocate their “generosity”.
It’s similar to the urge to buy a product if given a free sample of it.
We know from research in behavioural economics that making decisions in a ‘hot’ state (when emotional or excited) yields different outcomes. The happiness and surprise of receiving a windfall might likewise affect spending behaviour.
On the champagne trail, but there is a limit
For big windfalls, there are interesting dynamics in play, too.
Euromillions winners or recipients of a major inheritance anecdotally will often get advice on investing, spending and donating – which is perhaps not surprising given that a windfall of such a size substantially changes the expected lifetime income.
In the United States, the Milkman and Beshears review of research from the 1950s through to the 80s contains an interesting finding. They write that large windfalls increase a person’s propensity to spend money but that this propensity falls as the size of the windfall increases. In other words, a big, unexpected monetary gain will generally bring about spending, but a bigger fortune doesn’t mean that more is spent. (However, stories about lottery winners who squander everything show that there are exceptions to this.)
Rebates and spending patterns
That we spend windfalls differently to other income might help explain certain changes to spending patterns. Some even suggest that recent windfall refunds for PPI mis-selling in the UK have resulted in increased car sales. The average refund amount of around £3,000 is not enough for a deposit on a property, for example, but is just right for making a substantial dent in the price of a new car.
Putting a windfall to use
So what to do with your next windfall? Of course, using it to ensure that the basics are covered is a good place to start. Saving it in an emergency fund could help provide a buffer down the line. But if spending the windfall is your preferred route, a practical step is to put a limit on the spend – so if the windfall is £10, only spend £10.
Academics Elizabeth Dunn, Dan Gilbert, and Timothy Wilson suggest eight ways to spend money to get a bigger happiness bang for your buck.
Studies have found that spending a windfall on others rather than keeping it for yourself can boost happiness. Just as with spending, it may be psychologically easier to donate from a windfall "account" than from other forms of income. So even though the surprise of my small Give Mondays windfall soon wore off, I still had a warm glow from passing on the £10 windfall to charity.