Imagine yourself with your friend in the Sin City, i.e. The Las Vegas. While walking on the Las Vegas Boulevard you find a $10 bill sticking out from the side of the pavement, as if it’s telling you “Please Pick me!”. You pick it up and feel ecstatic about your moderately good fortune.
“Wait a minute! Is that a sign from the universe?”, a strange but perfectly reasonable thought appears in your thought screen. Perhaps the lady fortuna is nudging you to try out your luck using this $10 totem. After all it’s Las Vegas. The Gambler’s Paradise.
Your friend however is tired and heads back to the hotel. But you just can’t ignore the sign from above. Taking this as an omen, you enter the first Casino and head straight to the roulette table. You want to bet on your lucky number 7. Sure enough, the roulette ball hits 7 and 35-1 bet wins you $350. You let your winnings ride and the ball lands on 7 again, paying you $12,250. And so it goes. Within an hour you are a multimillionaire with $50 million in your kitty.
Feeling like Daniel Ocean from Ocean’s Eleven, you intend to bring the house down with your raging streak of luck. Being just one step away from becoming a billionaire you bet all your money on number 7 one last time – only to lose it all this time. Broke, dejected and little flabbergasted you walk down several miles to join your friend in the hotel room.
“Where were you man?” asks your friend as you enter the room.
“Playing roulette.” You’re still feeling a little shaken.
“How did you do?”
You cut the story short and tell him, “Not bad. I lost ten dollars.”
My question to you is – “Did you really just lose $10?”
If your answer is yes, then perhaps you are unaware of the behavioural bias called Mental Accounting.
This concept, first proposed by University of Chicago’s Richard Thaler, states that human beings have the tendency to categorize and handle money differently depending on where it came from, where it is kept, or how it is spent.
Are you confused a bit? Here is another thought experiment to get a better handle on curious effects of mental accounting. Try to answer the questions honestly.
Loss of IPL Ticket
Imagine you have bought a ticket to an IPL cricket match where your favourite team is playing. When you reach the venue you realize you’ve lost the ticket, which cost you 2000 rupees. Are you going to spend another 2000 bucks and buy a new ticket at the venue (assuming it’s available at the ticket counter) to see the match?
Your answer would probably be no. That was my answer too when I heard this for the first time.
Now let’s re-construct the same scenario little differently. Instead of buying the ticket beforehand you’re standing in the line to buy the ticket in the stadium. At the ticket counter you realize that you’ve lost 2000 rupees cash somewhere on your way to the stadium. Still, you have more than enough in your wallet to buy the ticket. What would you do in this case? Buy a ticket?
Intuitively, like most people, you’d probably answer yes. Like I did when I was asked the same question.
Irrespective of the fact, whether you buy the ticket again or not, aren’t both the cases setting you back by 2000 rupees? Then why is your behaviour different in above two cases?
You might say that the loss of the ticket and the loss of 2000 rupees aren’t the same. It’s possible that I might find either the ticket or the 2000 rupees later (that it’s misplaced instead of lost). However, the ticket will have become useless to me whereas the 2000 rupees will not have. But not everybody is so rational (and so hopeful about lost money) while standing at the ticket counter.
This inclination of human mind to mentally separate the two losses in different categories is a classic case of mental accounting. We shift perspectives on money as the surrounding circumstances change. We tend to mentally put money into different ‘accounts’ and that determines how we think about using it.
The economic theory says that money is fungible, and there should be no difference in the way we spend the bonus money and the salary income.
Think about it for a moment, won’t it sound ridiculous if your local grocery store guy tells you, “Sir! Since you’re paying using the money from your salary, I am going to give you 20% discount. However if you want to pay using the money from your diwali bonus, then I’ll charge you 20% extra.”?
But a similar logic seemed perfectly reasonable when we were buying the IPL tickets.
Earned Money Vs Found Money
Have you ever been guilty of spending your stock dividends (or the interest on fixed deposits) as if it was free money? Before you answer that let me admit that I have been guilty of this mistake multiple times in the past. I used to mentally compartmentalize the dividend money as excess money.
The outcome is that my salary (earned money) gets spent on my needs first however the year end bonus(found money) gets spent on discretionary items, like vacations, first.
Do you know somebody who pays 18% interest on revolving loans on credit card in spite of having money invested in bond funds earning 7% returns? It’s pretty obvious that his mental wall separating the two accounts is not going to come down for a long time.
For that matter plastic money (credit cards) is the scariest exhibit of mental accounting for messing up your personal finances.
Lollapalooza of Mental Accounting
The funny thing about mental biases is that they usually don’t come alone. In most cases there are multiple biases acting together creating a lollapalooza effect. So even in this case there is a subtle interplay of mental accounting and contrast effect.
Let me share my personal experience. Everytime I go for my monthly grocery shopping, I am always surprised at number of unplanned small items I end up picking. A 10 rupees cookie pack, a 15 rupees coffee sachet (even though I am a tea drinker) and a glittery ball pen displayed near the billing counter. We justify these small items purchases in contrast to a usually larger grocery bill.
This is what contrast bias does to you. I would never have bought those items if my final bill amount was going to be small. A brilliant insight found in the book Why Smart People Make Big Money Mistakes –
Mental accounting helps explain the one of the greatest puzzles of personal finance – why people who don’t see themselves as reckless spenders can’t seem to save enough…Although people are cost conscious when making large financial decisions – such as buying a house, car, or appliances – mental accounting makes them relax their discipline when making small purchases. The cost of such purchases gets lost among larger expenses, such as the week’s grocery bill…The problem, of course, is that while you might purchase a car or refrigerator every few years, you buy groceries every week or every day. Being cost-conscious when making little purchases is where you can often rack up big savings.
By the way, a side note – Psychologists suggest that you should never go for grocery shopping when you are feeling hungry. You would end up buying stuff that you don’t need unnecessarily bloating up your bill.
Sales people understand these quirks in human behaviour. They don’t shy away from exploiting these biases for their benefit. Now you can guess why consumer electronic stores promote the extended warranties so much at the time of purchase. Or why insurance agents push those exotic policy riders.
Side Effects of Mental Accounting
In some cases mental accounting can actually come back and bite you harder. Let me use my favourite thinking tool, hypothetical situations, to explain the point –
Let’s say you plan to spend 20,000 rupees for buying a smartphone. On the day of the purchase, you suddenly find a 10% discount deal and end up saving 2000 rupees on your phone. Research has shown that most people in this scenario start accounting those 2000 rupees as ‘found money’ and end up spending not just those 2000 bucks but some more to use up the free money.
So you see how the ‘bonus money’ can sometimes do more harm than good. It’s another mental accounting mind bender.
Overcoming Mental Accounting
If you grandmother gifted you 1000 rupees on your birthday, are you going to use that money for paying your electricity bill? Sounds insensitive right? You aren’t going to splurge the same money on gambling either. That’s the basic idea for countering the harmful effects of mental accounting. Convert every inflow mentally into “earned income” and then evaluate what do you want to do with it.
So imagine that all kinds of income is earned income including dividends from stocks, interest on fixed deposits, money found on the road, the diwali bonus from your employer, income tax refunds and for that matter even the money gifted from your grandmother.
Second trick is to delay spending any ‘bonus’ money. Just keep it in a fixed deposit for a month. Sleep over it before splurging it on anything. You would be surprised how quickly your brain re-categorizes your ‘bonus’ money to ‘earned’ money.
Another common sense approach is to limit the use(rather abuse) of plastic money. I have gotten into the habit of using my credit card only for online purchases (that too I prefer net banking or even cash on delivery option). Of course that increases my trips to the ATM but that’s the whole point. Spending money shouldn’t become so convenient that you end up spending all.
Exploiting Mental Accounting
I am a big fan of Nassim Taleb’s books. I like experimenting with his mental models wherever I can find some useful application. Antifragility is one such concept, which says that you arrange your affairs in such a manner that harmful effects generated by uncertainties (mental accounting) of life make you stronger and better.
So let’s see how we can actually not just shield ourselves from ill effects of mental accounting but use it for our benefit. This starts with the understanding that all human biases have a reason behind them.
Let’s assume that you are a perfectly rational human being. Before spending any money, you would always check the opportunity cost i.e. before buying nice t-shirt for yourself, you would ask what other things you are foregoing in order to have the new shirt. Obviously this process is too rigorous and nobody has the time and mental capacity to go through this exercise every time we spend money. So we fall back to the behavioural short cut of mental accounting by pre-assigning money for each cause.
Explained that way mental accounting doesn’t look all that evil. It gives us an easy and simple way to carry out our day to day financial transactions without too much of cognitive overload.
When you associate your money to a specific emotional goal, you channelize the will power to save money for that goal. Saving money for years to buy that dream house of yours or to buy that long cherished dream vacation in Europe.
In fact the first advice given by any reasonably good personal financial advisor is to create a do-not-touch emergency fund for yourself. The idea is to stash away some part of your saving in an ultra safe asset and not to touch it unless there is an emergency.
Here is an example of how Dustin Hoffman used mental accounting when he was struggling to make a career in Hollywood.
If I were to summarise mental accounting in one sentence, it would be – Reimbursements send people on trips to the bank, and bonuses send people on trips to the Bahamas.
So the central idea here is that money is not truly fungible in a human mind, and this oddity produces an irrational behaviour while dealing with certain situations involving money.
Although mental accounting can distort your thinking process and lead you to make erroneous decisions, with proper awareness it can also be used for our benefit.
If you are aware of this behavioural quirk, odds are high that you would end up benefitting from it over a long term instead of getting hurt from it.
Take care and keep learning.