How Mental Accounting Messes With Your Head and Finances

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Have you ever used a tax refund for frivolous things you wouldn’t normally buy? Would you treat the loss of a $20 bill differently from losing a $20 theater ticket? If you have a lucky run in the stock market, do you then take bigger risks with your profits?

These are all examples of what behavioral economists call “mental accounting.”

Mental accounting, a concept associated with the work of economist Richard Thaler, describes our tendency to treat money differently according to how we come to possess it.

In other words, even though, rationally, any $100 is the same as any other $100, how we came to possess that money often makes a difference in how we use it.

This tendency can have negative, even bizarre outcomes. For example, below I’ll tell you about a study that found taxi drivers often plan their schedule in such a way that they make the lowest hourly rate possible.

That might have you wondering what mistakes you’re making. So let’s start with a look at…

Unexpected or Found Money

The clearest examples of mental accounting are what people do with financial “windfalls.” A large tax refund, an inheritance, or any other unexpected or “found” money is almost always put in a different mental account or category than “hard earned” money.

This classic example is lottery winners who go bankrupt after spending millions on things they never would have normally bought..

When I worked as a blackjack dealer I saw this effect all the time. For most gamblers, there is a mental account for “their” money, and another for what they call “the house’s money.” The latter is their money, but because they won it they treat it differently.

For example, a typical player might never bet $100 of his money on one hand of blackjack. But if he’s winning, and is $1,000 ahead, he’ll say something like, “Well, I’m just playing with the house’s money,” and suddenly bet a $100 chip on a hand.

Worse, he will even play differently, making bad plays (like splitting face cards) that he wouldn’t normally make. I saw this just about every day I dealt blackjack.

Of course, once it’s won, the money belongs to him, not the “house” (the casino). The player is free to walk away with it and use it just as he would use any money he made from his job.

Have you ever blown your tax refund on things you don’t normally buy? That’s even more ironic than the casino example, because your refund is your hard earned money, just refunded because you overpaid on your taxes.

This mental accounting effect is seen in small windfalls too. For example, if you’re given a coupon for $10 off at an online grocery store, the rational thing to do would be to buy what you normally buy and so save yourself $10.

But that’s not what researchers found when they tried this as an experiment.

Here’s what they reported:

“Controlling for customer fixed effects and other relevant variables, we find that grocery spending increases by $1.59 with the use of a $10-off coupon. In addition, even though the receipt of a $10-off coupon does not correspond to a meaningful increase in wealth, the extra spending associated with the redemption of such a coupon is focused on ‘marginal’ grocery items, or grocery items that a customer does not typically buy.”

They bought more, and bought things they didn’t need. If you want to avoid this mental accounting trap, consider taking…

The Rational Approach

Treat all your money the same, and spend it without regard to where it came from or how much came into your hands or bank account at once.

One trick for being more rational with windfalls is to put them away in the bank for a while. When “found” money is intermingled with “regular” money for a few weeks, you’ll stop accounting for it differently in your mind (at least that’s my experience).

The Taxi Driver Experiment

A study of taxicab drivers in New York City provides a great example of how mental accounting can cost you a lot of money. The drivers interviewed for the study all paid a daily fee to use their cabs, and they could choose when to work and for how long.

To maximize hourly pay, drivers should have worked the hours with the best fares and tips.

And it would help if that meant working long hours on busy days, because if a driver squeezed 40 hours (assuming that’s all he wanted to work) into four days, he would pay only four cab rental fees instead of five, leaving even more profit.

What did researchers discover? As it turns out, many drivers did just about the opposite. They used simple mental accounting rather than a rational approach to maximizing their pay.

Specifically, they had an amount in their “mental account,” that they thought they should make for the day. Once they made that much they quit.

As a result, when fares and tips were coming in fast drivers met their benchmark early and quit, rather than take advantage of the rest of a busy day. When fares and tips were slow the drivers put in 12 hours or more to reach their mental goal.

Quickly quit when the money is pouring in, and work long hours when it trickles in — that’s a perfect way to make just about the lowest hourly pay possible. And it’s a good example of how mental accounting can cut your income in half.

Once you understand this you might think about making your weekend Friday and Saturday, so you can collect that time-and-a-half pay for Sunday. That brings us to…

The Rational Approach

Actually analyze financial matters, and from several perspectives, to find the most profitable way to proceed, rather than relying habitual mental accounting.

For example, you may need a certain amount of income to support your lifestyle, but if you value your time you should look for ways to maximize your hourly rate, so you can hit that weekly or monthly goal in as few hours as possible.

The Sunk Cost Fallacy

As explained on BehavioralEconomics.com, “Individuals commit the sunk cost fallacy when they continue a behavior or endeavor as a result of previously invested resources (time, money or effort).”

An example given is a person who, because he spent $20 on a concert ticket, drives hours through a blizzard to attend the concert, in an attempt to not “lose” his $20.

Normally he might not risk the drive or spend the gas money even if the concert was free, but these extra costs are paid because they’re in a different “mental account,” one associated with salvaging the initial ticket investment.

Another way to put it is that our financial decisions are tainted by the emotional investments we’ve made. The more time, money, and emotions we invest into something, the harder it becomes to abandon it, even when it’s the rational thing to do.

We “throw good money after bad” as the saying goes. Or we waste more time and effort in order to “redeem” an expenditure.

For example, you might sit through an entire bad movie, because you don’t want to “waste” the money you’ve spent. Of course, the money is already spent, and no amount of time watching a bad flick changes that.

Let’s look at a more expensive example. Suppose you buy an old car for $600, and the next week it needs $800 in repairs, and, once fixed, it will still be worth only $600. You might be tempted to fix the thing, just so you don’t “throw away” your original $600 investment.

Of course spending $800 to once again have a car worth $600 is irrational. You’re better off getting what you can for the car from the junkyard and then buying another old car.

The Rational Approach

Base your financial decisions on the the expected return (in money or pleasure) from what you’ll invest going forward, without regard to what you’ve already invested.

Imagination can help you mentally separate yourself from prior investments.

For example, in the concert example, imagine that, instead of having already paid for your tickets, you’re just now seeing coupons for free tickets offered in a newspaper. Would you clip them out and use them? If not, you can see that it’s time to throw the tickets away.

The Question of Value

What is something worth? The market value, determined by buyers and sellers, is not always as relevant as personal value. For example, for my personal use, a Rolex watch is worth no more than $50, no matter what the asking price is.

I’m not saying I wouldn’t be tempted to buy a $6,000 Rolex for $100, even if I couldn’t sell it. We all get a bit hypnotized by our concepts of value.

For example, Richard Thaler, in a paper on mental accounting, mentions a friend who bought a quilted bedspread.

They normally cost $200, $250, and $300 according to size, but they were all on sale for $150 each. So she bought a king-size bedspread, even though it was too big for her double bed, presumably to “get more value.”

I’ve done the same at our local Circle K gas stations, which charge 89 cents for any size soft drink. Even when I need just a small drink, and I get no extra personal value from having more, I tend to buy the largest size (and inevitably need a bathroom before long).

Objectively, value is not necessarily reflected by the price (unlike what our mental accounting tells us), but by the useful function of what we buy. For example, a winter coat is worth some amount, but we need only one, so a second (or sixth) coat has almost no value, because it does not contribute additional usefulness (unless bought for fashion reasons).

The Rational Approach

Value things according to what you need, what they’re worth to you, and without regard to what they’re worth to others or what the previous price has been.

Imagination can help here too. For example, if you’re tempted to buy something because it’s at a 50% discount, imagine that the previous price wasn’t double, but half of the current price. If the price had just doubled would you still be interested?

The Benefits of Mental Accounting?

Behavioral economists see those non-rational categories in your mind as harmful, and they often are, as our examples show. But mental accounting is only a problem when it leads you into decisions with negative outcomes.

What if you could use mental accounting in ways that helped you? Fortunately, you can.

For example, you could choose to mentally categorize tax refunds as debt repayment money. In fact, one poll found that 21% of people do exactly that, and another 61% save or invest that money.

Another mental accounting strategy is to categorize the last $500 in your checking account as “untouchable” money.

If you think of a $500 balance as $0 in the account, and avoid dropping below that amount, you’re less likely to have accidental (and expensive) overdrafts, and you’ll have additional money available for an emergency

Once you understand how mental accounting works, you can avoid unconsciously falling into its traps, and maybe even use it consciously for your benefit.

If you have your own examples of how mental accounting has contributed to bad (or good) decisions, please tell us about them below … and keep on frugaling!

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