Do you feel differently about spending your tax return than you do about spending your paycheque? Have you got separate spending accounts and saving accounts? Do you have credit card debt, but also some money stashed away for Xmas or a holiday?
Mental accounting describes that strange human habit of dividing money up into different mental categories for different purposes – even though on most occasions it isn’t quite as rational as it may seem….and can be detrimental to your financial health.
You see, money is ‘fungible’ (interchangeable) – it doesn’t matter what its for, what account it was in, whether it was earned, won, found, or a gift. It doesn’t matter whether it comes from a card, a neatly folded bill, or 2000 5c pieces in a piggy bank, $100 is $100 and it will buy you $100 worth of stuff. So why then do we make irrational and potentially damaging financial decisions by conforming to a subjective set of rules that define which money can be spent on what? Well, the answer (as with many things in life) is that we’re human. We suffer from all sorts of irrationality, emotions, and cognitive biases – mental accounting is but one of them.
In behavioural economics, there is a short anecdote that is used to describe the fallacy of mental accounting. It goes something like this:
Imagine you have set yourself a weekly lunch budget of $10 per day. On Wednesday you get to the café and as you’re about to pay, you reach into your pocket and discover the $10 note you had set aside for your lunch has fallen through a hole in your pocket. Do you buy a sandwich anyway?
Consider an alternative scenario. On Wednesday you get to the café, and purchase a sandwich, but as you go to take a bite you stumble and drop it onto the floor. Do you purchase another sandwich?
If you’re like most people, due to the mental accounting bias you wouldn’t consider the lost money part of the lunch budget because it never got ‘spent’ or allocated to the mental sandwich account. However, you’ll most likely feel like you have already allocated the money to the sandwich account in scenario 2, which may prevent you spending more and buying another sandwich. Of course in both scenarios the decision is exactly the same – do I spend $10.00 on a sandwich?
You may be surprised to learn that in an experiment conducted by Richard Thaler in 1985 (albeit with Movie tickets in place of sandwiches), only 46% of survey participants said they would spend an additional $10 to replace their lost sandwich, whereas a whopping 88% would spend an additional $10 if it was cash they lost, not a sandwich.
So let us take a look at how mental accounting hinders and how (on rare occasion) it helps.
1. Many people have a separate account for savings, but at the same time, they will also have high interest credit card debt. Refusal to touch your savings account (to pay off your credit card) could be costing you 20% interest per year! Pay off the card by borrowing from you savings account – pay yourself back in instalments as you would with your credit card.
2. People will often view their tax return as a windfall (not as a return of their overpayments to the taxman throughout the year… read more here). As a result they will spend this money differently than they would spend their wages. So maybe the tax return ends up being splurged on a shopping outing – where you pay full price for everything because its unexpected money and its not the same as the cash from your paycheque. Without a mental accounting bias people could buy what they want throughout the year – probably on special, and get it sooner!
3. Due to creating a separate mental account for each investment (and a couple of other unhelpful biases), people have a tendency to hold ‘losing’ investments because they feel like they need make their money back on the same investment. For example, you invest $10,000 in company A, and the share price promptly halves due to some negative news about the company’s financial performance – the value of your investment is now $5000. Many people will continue to hold on, waiting for their investment to rise 100% (back to $10,000) so they can recoup their losses, even though the financial results reveal that it is not a sound investment. Often the best approach is to re-assess the investment on the basis that is a brand new decision. (If I had $5000 to invest would I invest it in company A, or would I invest it in company B?).
You don’t need to make back your losses on the same stock… $5000 is $5000. Should you choose to sell company A in order to invest the proceeds in company B, your capital loss of $5,000 is offset against any future capital gains from company B. If company B rises 100% making you a $5000 capital gain and you were to sell, your $5000 loss would offset your $5000 profit and you would pay no tax. The maths is exactly the same for each scenario; so don’t hang on in vein just because you’re trying to balance the books of your mental accounts!
4. People tend to be more frivolous or take more risk with ‘found’ money than earned money. This is also known as the ‘house money’ effect, or gamblers fallacy – often a gambler will take bigger risks with their winnings than they would with their original cash. Money is money and it all has the same value – why should we treat it differently?
5. ‘Sunk cost fallacy’ – the need to get ‘value’ from what we’ve paid for… even though it may produce a terrible outcome. I once bought my sister and her husband tickets to a Cuban Ballet at Sydney Opera House. It was a birthday gift, but upon gifting the tickets my sister told me that my Brother-in-Law had already taken her! Damn I thought. Never mind, I’ll just sell them. Well, after a week of trying to sell them without any luck guess what I did…. Yep, I went to the ballet cause I had to get ‘value’ for my purchase. I had a terrible night. I had the best seat in the house, and the show was fine, but totally not my thing – I effectively just wasted a whole Saturday night.
So how can mental accounting help?
Well, some people wouldn’t be able to save without it. Sometimes to save for a car, a holiday, a wedding, or retirement, people need to segregate their funds based on purpose. It may not be ideal, and doing so may have significant ‘opportunity cost’, but at the end of the day if reaching your savings goal is the aim, and If creating a separate mental account for savings is the only way you’ll get there, it is the lesser of two evils.
When my wife and I bought our most recent house, I was thrilled that Suncorp allowed us to create multiple ‘sub accounts’ as part of our main mortgage offset account. Each sub account can be used for a different ‘purpose’, but the combined balance of all accounts is the amount that offsets our mortgage – effectively they all earn 4% interest!
My wife and I always like to ensure we have an ‘emergency account’ so that we have some cash on hand if there is an urgent and unexpected need for it. Previously this was stored in a high-interest account in a separate bank. Lets say it was earning 3% p.a in interest. After the purchase of our house, it made much better sense to have as much cash as possible in our mortgage offset account (its better to save 4% than it is to make 3%), however, moving all of the funds into one account would mean that our emergency account was no longer ‘separate’, and perhaps we’d be tempted to dig into it.
The Suncorp ‘sub accounts’ allowed us to setup a separate ’emergency account’ and helped us satisfy our mental accounting bias without being detrimental to our financial health!
On a side note, many people don’t appreciate the difference between 3% and 4%… the ‘absolute difference’ is 1%, but the ‘relative difference is 33.33%!!! That means if our interest earned in the 3% ‘savings’ account was $1000 p.a, our savings from putting it in 4% offset account would be $1333.00.
Now transpose that maths onto your elderly grandmothers retirement saving balance. $500,000 earning 3% makes you $15,000 per annum in income – a 4% interest rate earns you $20,000…. Not such a small difference now huh?
As one of your fellow humans, i can tell you that despite my best efforts and the fact that i know better, i occasionally fall victim to cognitive biases and the fallacy of mental accounting (you’re kidding yourself or you’re a robot if you think you don’t). We’re all affected, and none of us are perfect, but with a better understanding of our built in flaws, and a lot of practice we can learn to make better decisions and increase our financial health.
One of the keys to avoiding cognitive biases and emotional errors in judgement is being aware that they exist and learning about them! We’ll take a look at a few more in the coming weeks.