The denomination effect

One of the top tips to control spending is to take out money from bank machine and only pay in cash. The thinking is that when you see what you’re spending, you won’t spend as rashly as you might if you paid with a debit or credit card.

Even better, if you take out larger bills, you won’t spend as much, the theory being it’s more fun to have $20s and $100s in your wallet versus $10s and $5s. This is called the denomination effect.

Simply speaking, people are less likely to spend bigger bills than the same amount in smaller bills. In other words, people are less likely to spend a $20 than they would four $5 bills.

The term is derived from a paper by Priya Raghubir and Joydeep Srivastava, published in the Journal of Consumer Research in December 2009.

In an experiment, the researchers gave approximately 90 business school students either a dollar bill or four quarters, then told them they could either keep the money or buy candy. What they found was that 63 per cent who got quarters bought the candy, but only 26 per cent who got the dollar bill spent it.

According to Raghubir and Srivastava, “The results suggest that the denomination effect occurs because large denominations are psychologically less fungible (interchangeable) than smaller ones, allowing them to be used as a strategic device to control and regulate spending.”

A savings strategy
It’s a solid theory, but does it apply it to your bank account? Will the denomination effect work on your savings?

Shannon Lee Simmons, a Toronto-based certified financial planner, has seen the effect with her clients. “I find clients with large balances in their checking account (not savings) are less likely to purchase large things for sure,” she says. “People like to see a large balance.”

Here’s how to turn the denomination effect into a tool to help control spending and build savings:

Don’t break up your money in too many accounts. While it’s also not advisable to keep all your money in one account (there is the risk should your account be compromised), consider keeping just two — a chequing and a savings account.
Pay in cash. Using a debit or credit card hides your money and you don’t see the numbers going down. “If a spender is using credit for most purchases and carries debt, even a small amount, it’s likely they are less afraid to spend more money since they may not feel like there’s a point,” says Simmons. “If they are paycheque to paycheque in their chequing account and have been for a while, they are less afraid to be at zero or owing.”
Create a budget. You know we were going to say this, but this way you know what’s coming out and what’s going in. That gives you your baseline for what should be left as a balance. Once you have that number, you know where you want it to stay.
Check your accounts weekly. Don’t just rely on your monthly statement. By getting into the habit of checking your statement on a weekly basis, you’ll be more likely to want that number to stay constant.
As Simmons says, “If you’ve got a lot of money in chequing — it’s fun to look at and you don’t want to see it go down.”