DON'T BE A VICTIM OF MENTAL ACCOUNTING

By in Mind and Money | 15 comments

Behavioral Finance Topic

Growing up, an adult cousin advised me to “splurge with money received as a gift.” She reasoned that since the money was not expected, it was “found money”. This advice never sat well with me. As an adult, I realized this was an example of “mental accounting”. Mental accounting is the belief that money can be used for different purposes, depending upon its origin.

Mental Accounting

Mental Accounting

This is an irrational belief.

One of my favorite topics in the university Investments Class I teach is Behavioral Finance. I’m fascinated with how we consider ourselves rational and yet practice really stupid money practices. Researchers have uncovered many of these irrational behavioral biases. They are supremely important in investing and can cause investors to buy high and sell low… and who wants to do that?

Richard Thaler, famous behavioral economist and author of Nudge uncovered this bias in the 1980’s. Since then many have pondered:

Would you drive 20 Minutes of of your way to save $5 on a $15 calculator?
or
Would you drive 20 minutes out of your way to save $5 on a $125 leather jacket? Forbes, Jonathan Becher

Turns out that 68% would drive to get the deal on the calculator yet only 29% for the leather jacket. In reality, the $5 is the exact same amount. Why would one drive out of their way to save 33% on the calculator and not 4% on a leather jacket? We feel like we are getting a better deal on the calculator than on the jacket.

Spend Your Dividends, Reinvest Capital Gains?

How many have heard the old adage that retirees should reinvest capital gains and spend dividends? Another example of mental accounting that makes no sense. Whether you spend your dividends or capital gains, makes no difference whatsoever. The source of the funds does not change the fact that its all just money. $100 in dividends is no different than $100 in capital gains.

The reason so many lottery winners end up in financial trouble is because they choose to splurge with their winnings to an unrealistic extent. Many of these lottery winners go out and buy boats, mansions, and more and run through the money like water. Had they “earned” the lottery money, they would be much more careful with their winnings.

Don’t be Fooled by Mental Accounting

The source of funds has nothing to with how money should be spent or evaluated. When you buy a new car for $25,000 and the dealer attempts to sell you the $400 extra super special protective coating do you think, “Well, it’s only another $400, why not?” Or do you think, there are a lot better uses for an extra $400 than this coating which may or may not preserve my car’s paint job.

Regardless of it’s origin or context, money is a commodity. It is the same whether it came from the lottery, Aunt Jeanette, earnings, or an investment. Treat your money with respect and spend it wisely. Don’t be fooled by mental accounting.

Share your examples of mental accounting. Come on, I know you have them!

image credit; google images_riyaz dot net

    15 Comments

  1. I have to admit I was a victim of this recently. I had some extra money in my brokerage account that I was not expecting. I decided to use it to buy some risky tech stocks. Maybe they will pay off, but I probably should have used it to invest in something more sensible. But I was viewing it as unexpected “found” money.

    Tim Lemke

    March 25, 2013

  2. The one that’s popular right now is for people to spout the advice that you should never get a big tax refund, and instead you should keep the money and earn interest on it yourself. With interest rates as low as they are, a $4,000 tax refund would have likely yielded you around $20. Where mental accounting comes into play is that if you spend $20 or more of that money throughout the year (and let’s face it, most people would), you would have been better off letting Uncle Sam hold your money. It ties to your point that if you have money in front of you, you’re more likely to spend it than if it’s not there.

    Money Beagle

    March 26, 2013

  3. @Tim, Thanks for the “real life example”. I hope your risk pays off. This type of behavior is so ingrained it’s really difficult to recognize mental accounting in the moment.
    @Money Beagle-In today’s low interest rate environment, your point is well taken. The key is to use the tax refund wisely when you receive it and not look at it as “found money.”

    Barb

    March 26, 2013

  4. Very interesting question! I stopped driving for the extra money off and just buy it online. No additional costs and usually a coupon code too. I taught my children to save at least half of any money whether gift, promotion, merit increase etc. It was something I learned as a child and I still use it.

    krantcents

    March 26, 2013

  5. I love this post it really makes you think. Nowadays I just buy most the things I need online, and the things I don’t buy online, in all reality, i’m lazy and wouldn’t travel far at all for a small discount. The way I see it, the money I save online by comparing prices pays for my lazyness in the real world.

    John

    March 26, 2013

  6. Not sure it fits exactly within this category, but it drives me batty when people buy something on sale and decide to buy more because they “saved” so much money on the first purchase…ack!

    The Happy Homeowner

    March 27, 2013

  7. These are excellent. I spent my entire career correcting people’s mental accounting habits. I loved it when people would decide that one family member wouldn’t work because it would just shove them into a higher tax bracket…..

    AverageJoe

    March 27, 2013

  8. Mental accounting is an excellent topic! One great example is how people do anything to avoid something labeled as a “fee”. We spend $5 driving out of our way to avoid a $2 ATM fee and we put up with 0% interest in accounts to avoid maintenance fees.

    A more subtle example (and one I have fallen victim to myself) is attempting to diversify every account in isolation, which is of course treating each account separately. This results in smaller position sizes, higher fees, and an inability to take advantage of special deals you may have with certain accounts. Diversification across all similar accounts (e.g. taxable or IRA) that you own typically provides a better cost structure.

    S. B.

    March 28, 2013

  9. Very good insight! In the 80s we bought a big ol’ Crown Victoria. Used, it was really cheap. But everyone was aghast: what about the gas mileage?

    What they didn’t see was the savings on insurance (a bigger expense than gas) was more than the penalty on gas. Furthermore, simply by eliminating a few trips we could save gas money, but the insurance payment always stayed the same.

    William @ Bite the Bullet

    March 28, 2013

  10. In response to Money Beagle’s comment – I think the larger risk (for those who overwithhold and have an April windfall) is that they will treat the refund as a windfall, and use the mental accounting to use it for something frivolous.
    If they use it to fund their IRA, that’s great, but if they were doing that, why not adjust their W4 withholdings and make the deposits through the year?

    JoeTaxpayer

    March 28, 2013

  11. @Krantc-I love the idea of shopping online to save money and gas. It also saves time!! That is a great idea to teach your kids to save half of their earnings!! Wonderful model!
    @John-Wow, that’s two for buying online! I think you are the “good type of lazy.”
    @Happy-I love when my Kohl’s receipt says I saved $90!! :) Even though I saved $90, I still “spent” real money!! Whenever you buy something, you are still spending, whether it was on sale or not.

    BARBARA FRIEDBERG

    March 28, 2013

  12. @Average Joe, Correcting mental accounting errors is a full time job. Even if we are aware of them, they are sometimes tough to combat.
    @SB-Great examples. It’s fascinating how often we make really senseless decisions about money. The driving out of your way and spending money on gas, just to avoid an ATM fee is a wonderful example.
    @Bill, That’s another great example. If you save $5,000 on the price of a car, and insurance costs as well, it takes a lot of gas to offset the savings.
    @Joe, That’s my concern as well.

    Barb

    March 28, 2013

  13. Great post. This happened to me this weekend. I went to a concert and I took some cash to pay for the tickets and when of my friends decided to give me her ticket for free I thought I had saved myself some extra money. In turn I immediately spent the money I was supposed on the ticket on buying drinks for the group. This was pure rationalization on my part!

  14. We live very close to the state line and the state south of us always has much cheaper gas prices, however, the price isn’t so cheap that it warrants the half hour round trip to fill up the tank. You spend your savings in the gas it costs to drive there and back. Still, I can’t tell you the number of my friends who make that drive every week.

    CollegeMom

    March 29, 2013

  15. @Kevin, Really nice example. The thing is, if we spend unexpected money, when we have “unexpected expenses” then we need to make sure we have the available cash. It’s great to get unexpected cash, but it’s not always a great idea to “blow it”.
    @ College Mom-Excellent example, tons of folks participate in this driving around, burning fuel to save a few cents per gallon on gas.

    Barb

    March 31, 2013

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