Put yourself in this scenario: You’re planning to go to a show tonight. A ticket costs $150, which you’ve already purchased the day before. When you arrive at the show this evening, you realize you left your ticket at home on the table. You don’t have enough time to go home and get it. Do you purchase another $150 ticket at the door?
Now envision a different scenario: You’re planning to go to a show tonight. A ticket costs $150, and you plan to purchase the ticket at the door. Earlier that afternoon, while at lunch, you realize that your wallet, which contained $150, had been stolen. Do you still go to the show tonight and buy a $150 ticket at the door?
In the first scenario, many people will refuse to purchase another ticket at the door. The feeling that the other ticket has been “wasted” because it was left at home, makes us feel like we’re now paying $300 to attend the show instead of $150.
However, in the second scenario, many people will still purchase a ticket and attend the show. The fact that $150 was lost elsewhere feels like an unrelated event, and therefore shouldn’t impact the decision to attend the show.
Notice that, even if you would buy a ticket in both scenarios, it feels different. For most people, buying another ticket in the first scenario stings a bit more than buying a ticket in the second scenario. Why? Both scenarios are mathematically identical. You either enjoy the show and you’re out $300, or you don’t enjoy the show and you’re out $150.
What’s going on here? Financially, there is no difference whatsoever. So why does it feel different? Why is it harder to commit to spending $150 at the door in the first scenario?
Why do we think this way? Mental accounting!
We keep our money in different accounts. Sometimes, those accounts are physical, such as a savings account, chequing account, retirement account, education savings account, etc. However, sometimes, those accounts are purely in our own minds.
Mental accounting is a cognitive bias that is based on the idea that we often assign different mental accounts to our money, and that often flawed logic then dictates how the money can or cannot be spent. In the two scenarios above, the cost of attending the show is a separate mental account.
In the first scenario, the $150 spent on purchasing a ticket the day before has already been associated with that mental account. Spending another $150 at the door gets allocated to the same mental account, making you feel like you’re now spending $300 to attend the show.
But in the second scenario, the money lost at the restaurant isn’t in the same mental account as the cost of attending the show. Therefore, spending $150 at the door to purchase a ticket still feels like we’re only spending $150 to attend the show in scenario one.
Notice, however, all of this spending is likely from the same physical account – your savings account. In neither case were we talking about dipping into emergency savings, or retirement savings, or otherwise. But because the spending occurs in different mental accounts, we analyze the two scenarios quite differently, and often reach different conclusions as to how we would proceed.
Why wouldn’t you want to save $20?
Still not convinced? Let’s try another one. Assume you’re looking to purchase a couple of different items – a new calculator, and a laptop computer.
You’re at a store that sells the calculator you want, and the price is $39. However, before making the purchase, you find out that another store is selling the exact same calculator for only $19. The other store is about a 20 minute walk. Would you go there? Most people say yes.
Now assume you’re at a store that sells the laptop you want, and the price is $1,299. Again, before making the purchase, you find out that another store is selling the exact same laptop for only $1,279. And again, the other store is about a 20 minute walk. Would you go there? Most people say no.
Again, we have the exact same savings of $20 in each case. And yet, in one scenario it feels like it’s worth it to achieve the savings, and in the other case it feels like a waste of time. Why?
You now know why – mental accounting. Although the money is, once again, all likely attributed to the same physical account (your savings account), the purchases have been assigned to separate mental accounts. In the account of the calculator, a cost of $39 has been projected. Therefore, a $20 savings is actually more than 50% savings – great! However, with the laptop, the savings of 1.5% seems irrelevant.
In both cases, you’re presented with the same savings opportunity – walk 20 minutes to save $20. And in both cases, the impact to your net worth is therefore also identical – walking 20 minutes increases your net worth by $20. Yet, in one scenario it’s worth it, and in the other, it’s not.
Does “found” money exist?
Another common area where mental accounting shows up is how we deal with refunds at tax time. Consider the following scenario: You’ve made some RRSP contributions throughout last year, and you now receive a pretty good refund – let’s assume a refund of $3,000. What should you do with this money? Invest it wisely? Treat yourself to a nice vacation down south?
Many people would generally have no problem spending a $3,000 tax refund on a nice trip down south. However, many of those same people would likely be reluctant to take the same $3,000 from their savings account and spend it on a trip. Why?
The $3,000 tax refund feels like “found” money. It feels like money that wasn’t previously in the budget. But the savings account feels different – you worked hard and saved hard for that money. It didn’t just appear like the tax refund, and spending from the savings account would feel more irresponsible.
Again, this is mental accounting at work. Regardless of the source of that money, when you own it, it’s all your money. Whether you’re spending a tax refund, or dipping into your savings, spending $3,000 reduces your net worth by $3,000. It doesn’t matter where the money came from.
How mental accounting can hurt your finances
Mental accounting can lead to poor decisions in many other areas as well. For example, consider someone who has $1,000 in savings for a rainy day, which is earning 1% interest, also has a $1,000 credit card balance, which carries a 19.95% interest rate, but refuses to use the savings account to pay off the credit card. Why? Again, because the savings money is in a different mental account and simply can’t be touched. Note, however, while it feels responsible to leave the savings intact, this is actually a very expensive decision. In reality, you are guaranteed to lose.
When dealing with investments, we also see mental accounting corroding our decision-making process. Perhaps the most common scenario involves the concept of house money. Similar to the idea of gambling in a casino, investors are typically much more willing to take risks with their gains (that is, house money) than they would take with their own capital. The mental accounts therefore become original capital, and profits (house money). As a result, many investors fall into the trap of investing original capital too conservatively, while taking careless risks with their investment gains.
Money is fungible. It is interchangeable. A $50 dollar bill earned from hard work is no different than a $50 bill found on the street. Although you may indeed feel very different about how you spend each of those $50 bills. For most people, depending on the source of that money, it feels okay to spend it frivolously in one case, and feels somewhat irresponsible (at least we hope so) in the other case.
Cognitive biases cause us to make decisions that are not in our best interests. And while mental accounting is a very common bias, it is just one of many traps that can plague our decision-making process. Stay tuned for more!