Do you treat spending out of your current bank or cash balance as “spending out of current income” and credit card spending as “spending out of future income”?
Or, do you treat investment in a particular stock as standalone from others – like, holding on to that stock till it is in the profit territory?
Or, do you spend dividend income from a stock investment, while not touching the capital appreciation?
Or, do you set aside some money in your bank as savings, while taking costly loans for some other spending – say, leisure?
If your answer to any of the questions above is “yes”, then you are a victim of mental accounting bias.
Well-known psychologists Amos Tversky and Daniel Kahneman did an experiment – they asked two questions to people:
- Imagine that you have decided to see a play where admission is $10 per ticket. As you enter the theater you discover that you have lost a $10 bill. Would you still pay $10 for a ticket for the play? 88% of the respondents said “yes”.
- Imagine that you have decided to see a play and paid the admission price of $10 per ticket. As you enter the theater you discover that you have lost the ticket. The seat was not marked and the ticket cannot be recovered. Would you pay $10 for another ticket? Only 46% respondents said “yes”.
In the second case, the respondents treated the loss of ticket as part of the mental account that was allocated for “spending for ticket” account. So, they were unwilling to spend yet another $10 for buying the ticket.
However, in the first case, the loss of $10 bill was treated as not related to the ticket purchase, and hence was not part of the “spending for ticket” account. Hence, they were comfortable in spending another $10 for buying ticket.
For a rational person, whether it is the ticket, or the $10 bill that was lost, it should not matter. In both cases, the monetary loss is $10. Whether to spend another $10 should depend only on whether you have enough money (or overall budget) to pay for it.
People treat one sum of money differently from another equal-sized sum based on which mental account the money is assigned to.
We have a habit of categorizing various sums of money into different buckets – based on type of expense (food, necessities, entertainment, luxuries etc.), or based on goals (kid’s education, retirement etc.). Further, these buckets or categories are treated as non-fungible (that is, not interchangeable). This is despite the fact that money is fungible.
Generally, people tend to view incomes from lottery or gift as different from salary income. Also, they treat wealth from inheritance different from wealth created by themselves. Income from salary and wealth from inheritance are likely to be spent more lavishly, than others – because we feel that it is “free money”, or “found money”.
A former colleague of Richard Thaler establishes a target donation to the local charity, at the beginning of the year. Then, if anything unexpected happens to him during the year, for example an undeserved speeding ticket, he simply deducts this loss from the “charity account”.
Here is another example from Tversky & Kahneman’s paper – based on Savage & Thaler. Two versions of this problem were presented to different groups of subjects. One group was given the values that appear in parentheses, and the other group, the values shown in square brackets.
“Imagine that you are about to purchase a jacket for ($125) [$15], and a calculator for ($15) [$125]. The calculator salesman informs you that the calculator you wish to buy is on sale for ($10) [$120] at the other branch of the store, located 20 minutes drive away. Would you make the trip to the other store?”
The result? 68% of the respondents were willing to make an extra trip to save $5 on a $15 calculator; only 29% were willing to exert the same effort when the price of the calculator was $125. This was because, they treated the purchase of jacket and calculator as part of separate mental accounts.
You might have already experienced this. When you bought your $100k car, the salesman would have tried to sell you some extra stuff such as a fancy audio system or touch screen which would have cost an extra $1,000. When you bought your $500k house, you might not have felt the need to bargain for an extra discount of $5,000. The extra $1k or $5k felt as just a small percent (1%) of a bigger purchase. But if you were buying a new laptop for $2,000, will you pay $1,000 extra? Nope.
So, how can we fight this bias?
Whether the money you have is from current income, inherited wealth, or even lottery prize – all money are the same. Have you ever seen a marking on the dollar bill as “current income to be spent”, or “lottery income to be splurged”?
Use these tricks to beat your mental accounting bias:
- Pay off your high cost credit card loans, if you have low-earning money in your savings account (which you don’t need urgently.)
- When you spend using credit cards, take care to treat each purchase as adding up to a bigger number – and not as an insignificant piece of a larger whole. Little drops of water make a mighty ocean.
- Buy only what you really need. Do you really need it, or are you buying it because it is a small part of a bigger purchase?
- Don’t splurge your bonus on an expensive holiday. Treat it like a normal paycheck. Another way to think about it is – “what if the bonus was a monthly payment?”. Would you keep it aside for your holiday, or for something more important?
- It actually helps to set aside money for kid’s education or retirement. But, think about them as part of the overall portfolio. You might put money in fixed deposits for your kid’s education, but might also take huge risks (say, financial derivatives that you don’t understand, or high-risk start-ups) in your “get rich quick” mental bucket. Don’t do it.
Mental accounting biases are very problematic in our investment decisions. Here’s how to deal with them:
Treat your investments as part of a portfolio. For example, you invested in Rio Tinto and BHP Billiton. You can’t treat them as separate investments. Of course, there are company-specific differences. But, they do business in the same sector – and hence their successes are highly correlated to each other. If there is a downturn in the mining sector, both these companies will suffer. Various investments in your portfolio might be correlated to each other in varying degrees. So, when you invest in something, understand how the new investment impacts your overall portfolio.
Treat dividend/ interest income and capital appreciation as the same thing. Investors have a tendency to spend the dividend income, but preserve gains from capital appreciation. This is against the concept of fungibility – whether it is dividend or capital appreciation, both are incomes. Think them as part of your total returns. If you don’t need the money from dividends for spending, reinvest the rest. Whenever you need money for spending, liquidate your investments, which you feel have the least upside.
Purchase price of investment is irrelevant. Mental accounting is sometimes related to sunk cost fallacy. For the current investments, we tend to treat the purchase price and the prevailing market price as part of the same account – and then see whether the investment made profit or not – to decide whether to sell or not. This is absurd. The only thing that matters is whether the investment will go up from here or not. It doesn’t matter whether we made a profit or loss – that is, the purchase price is irrelevant.
Money is fungible, whichever account you put it in. (Money doesn’t know which account you’ve put him in!)
Also, have a big-picture idea of your personal finances or investment portfolio while taking every spending or investment decision.
Amos Tversky; Daniel Kahneman: The Framing of Decisions and the Psychology of Choice
Richard Thaler: Mental Accounting Matters
Washington Post: Mental accounting
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