Philip Bish* says having a budget is a great personal practice, but it can also come with an interesting psychological quirk that may be costing people money – it’s called Mental Accounting.
The term ‘Mental Accounting’ was coined by behavioural economist Richard Thaler and describes the inclination to categorise and treat money differently, depending on where it comes from, and how it’s spent.
In his book Nudge, Richard Thaler tells the story of Dustin Hoffman and Gene Hackman, who in their early days, were struggling actors trying to pay their bills.
On one particular day Gene Hackman was visiting Dustin Hoffman’s apartment.
Soon after arriving, Hoffman asked Hackman for a small loan of $5.
Hackman agreed, but then went into the kitchen to find a row of jars filled with money on the kitchen ledge.
One jar was labelled ‘Rent’, another ‘Entertainment’, and another ‘Books’ and so on.
Hackman asked Hoffman why he wanted a loan when he had all this money.
Hoffman answered by pointing to the food jar, which was empty.
The story perfectly illustrates Mental Accounting, which is the ‘home’ equivalent of financial accounting.
It’s where people create spending accounts in their head, with implied budgets for activities such as entertainment, travel and clothing.
If there’s an overspend in one area, mental accounting will stop purchases in that area, but happily continue spending in other areas.
We use mental accounting for the purposes of self-control, but sometimes there is a cost for this self-control.
Though many people use Mental Accounting, few realise its logical deficiencies.
In one particular study it was found that if a person buys a $10 movie ticket and then loses it, only 46 per cent of people would replace the ticket.
However, if a person loses $10 of cash before buying the ticket, then 88 per cent of people said they would still buy a ticket.
The reason for this, is that losing $10 cash is seen as a loss to the ‘overhead’ account, whereas losing a ticket and buying another ticket, takes $20 from your entertainment account, which feels expensive.
Another quirk of Mental Accounting is that people may have money saved away in a low interest savings account for a holiday, while still carrying substantial high-interest credit card debt.
Mental accounting also explains how we spend our tax returns.
While our salary is normally used to pay our daily bills, a tax return is seen as a bonus or ‘found money’.
Thus, people feel free to spend it on discretionary items such as a new TV.
Another example of Mental Accounting is the ‘House Money effect’ which gets its name from the phrase ‘playing with the house’s money’.
Its premise is that people are more willing to take risks with money that they have obtained easily or unexpectedly, in an ‘easy come, easy go’ fashion.
The easy money may come by way of gambling, winning a competition, the sale of a house, a highly profitable stock trade, or an unexpected inheritance.
In stock markets, the House Money effect can be seen after a highly successful trade, where traders often use their winnings to buy more high-risk stocks.
The effect was seen during the dotcom bubble, where traders who had seen their stocks rise by multiples, would then use that money to buy into the next hot stock, hoping for similar success.
This effect contrasts with the way people deal with ‘hard earned cash’, where there is often a hesitancy to buy risky stocks.
The reason for this is that the person knows the work that’s gone into earning that cash and they don’t want to lose it.
Even though the way we treat house money and hard-earned cash can be quite different, the reality is that they’re both the same, in that they are still money.
When it comes to house money, we should always think of it as the same as hard earned cash.
And in that way, it will cause us to use it wisely.
Budgeting is a great thing to do, but we must be aware of Mental Accounting.
Here are four ways we can do so:
- Remember that every dollar we own, is the same as every other dollar we own.
- Always think of ‘easily won’ cash, such as bonuses or tax returns, as the same as hard earned cash.
- If you have a highly successful stock trade and want to cash out, don’t put your winnings into other risky stocks.
Rather, buy low-risk ETFs or Managed Funds to ensure your money is preserved.
- If you have low-interest savings but also a high-interest credit card balance, consider paying off your credit card balance with your savings.
This will help remove your high-interest credit card costs.
Once this is done, then continue saving.
*Philip Bish assists in the coverage across the ASX, Exchange Traded Funds (ETFs) and Listed Investment Companies (LICs) at InvestSMART.
This article first appeared at investsmart.com.au.