By in Mind and Money

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?
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