Mental accounting is a phenomenon noticed by Richard H. Thaler – as humans, we tend to make financial decisions based on perceived value and not absolute terms. We don’t see money as being fungible (interchangeable), but we tend to categorize it in a personal manner and make irrational decisions based on this.
While each dollar is … the same as any other dollar, our personal view on it makes it look more ‘valuable’ or not, compared to others.
If this sounds weird, let me explain.
Say you go to see a show and are ready to pay $100 bucks for it. You buy the ticket and then lose it. Chances are you won’t buy the ticket again, even if you do have the money in your pocket. There’s no way you’d pay TWICE for the same thing, right?
Yet, if you lost 100 bucks on your way to the show, and had enough money for the ticket, almost 100% you’ll buy that ticket and somehow put the 2 ‘losses’ in a separate category, even if you, at the end of the day, are 200 bucks short.
In Why Smart People Make Big Money Mistakes And How To Correct Them: Lessons From The New Science Of Behavioral Economics, Gary Belsky recollects the tale of the man in the green bathrobe, which also describes well the mental accounting phenomenon.
A couple went to Las Vegas on honeymoon and after calling it a night, the groom finds a casino chip in his green bathrobe and hears a voice telling him, “Joe this is the one“. There’s a 17 number on the chip and he’s convinced he’s gonna get lucky.
He plays the $5 chip on 17 over and over until he wins $268 million.
Instead of taking his money and leaving the casino, he plays it once again and loses it all, when the ball lands on 18.
He gets back to his hotel room and the bride wakes up and asks him about his whereabouts. He tells her he went to the casino and, when she asks him how he did, his reply comes “not too good; I lost $5”.
Mental accounting in this case makes him see the 268 million bucks as the casino’s money, even if it was his, provided he stopped gambling.
Now that we got an idea about how mental accounting works, let’s see few of our mistakes and how we can avoid them.
Mental accounting mistakes we could avoid
Tax refunds, inheritances, work bonuses
Most families have a budget.
It’s the best way to keep on track with your debt payment and reach your financial goals easier.
By having a budget, you have all your income and expenses mapped out for almost each month.
Then you get a hefty tax refund. A small inheritance. A work bonus.
And most likely, instead of saving the money or paying off more debt, you go to spend at least some part of it.
Because it’s unexpected money and somehow you feel like it’s not money that has an impact on your financial well-being. And a windfall isn’t as ‘important’ as your salary or regular savings, so you are entitled to squander it.
How can you avoid this?
Decide from the get go that every windfall will be used to pay off debt faster. Or make your emergency fund bigger. Or maybe fund your children school savings account.
This way, when you do get the money, you won’t squander it.
Most families give their children some sort of allocation, to buy stuff, pay for trips or learn how to save money from an early age.
Mental accounting, as you have guessed, makes the kids feel like birthday money is not ‘regular’ money, so it can be spent recklessly.
It’s your duty as a parent to teach your youngster to set a good goal for this money and afford a new gadget faster or pay for their school trip.
Money you can afford to lose
This is pretty common with investors who view some part of their investing money as capital for investing in very risky options. Some sort of ‘play money’ if you like.
It looks like a smart idea to not bet all your investing money on speculation, but experienced economists would advise to stay away from any deals that are prone to lose you money.
On the other side of the financial spectrum people have their safety capital. Money they very carefully budget and manage, since otherwise they’d be late on rent or mortgage, have no food on their table or any other disastrous situation.
You might argue that it’s a good idea to treat at least some of your money with a lot of care, since it’s important for your family’s well being.
And yet, just as with the previous option – why not care for ALL your money?
This is mental accounting all the way – most people who win the lottery will squander their money.
Statistics show that most people who earned millions at the lottery ended up poorer in just few years, because they couldn’t see that money as rightfully theirs and properly manage it.
Different currencies make you feel like money has different value
Let me explain.
In Romania we have the ‘Leu’, this is our currency. It’s about a quarter of a dollar and about 1/5 of an Euro (approximately, an Euro is about 4.6 Lei, but it’s not as relevant).
I usually buy my kiddo clothing from our regular stores and, since she’s a 4 year old prone to get it dirty and overgrow it in few months, I’m not paying top bucks for it.
A t-shirt is routinely about 3 bucks and a pair of pants not more than 7-8 bucks. I just don’t feel like spending more.
Let’s say that, when visiting Italy, I had no problem getting her an United Colors of Benetton tee for 13 euros (which was almost 60 lei) or spend a small fortune for a day at Leolandia (a local amusement park). Together with my best friend we spent close to 200 bucks, which in Romania was 800 lei.
Some people here work 3 weeks for this money and we squander it in a day.
Why? Because 100 bucks doesn’t look as bad as 400 lei, even if it’s the same.
In order to curb my stupid spending, I started calculating how stuff would cost in Lei and not Euro and was able to make fewer mental accounting mistakes.
These are just few examples of how mental accounting can ruin your finances. Stay close for a new article on how to stop mental accounting and get control over your money once again.