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Mental Accounting and Decision Making

24 Feb 2015 12:36 PM - Article written by RSP consultant, Richard Wright

When is a dollar not a dollar?

We all understand that two five dollar notes have exactly the same purchasing power as a single ten dollar note. Essentially all money is interchangeable. But do we always treat it that way?

Think about times when you have received an unexpected financial gain. It could have been a work bonus or even a win at the races or casino. Chances are that you allocated some of this ‘free money’ for a special purpose independent of your general budget plans. If so, mental accounting was at play.

 

Accounts in our head

Mental accounting refers to the tendency for people to separate money into distinct accounts and earmark it to be spent on certain things.  This can lead to all sorts of irrational decisions not in our best interests.

 

Consider the following scenarios presented to students in a study;

Scenario 1: Imagine that you have decided to see a movie where tickets cost $10. As you enter the theater you discover that you lost a $10 note on the way. Would you still pay $10 for a new ticket?

Scenario 2: Imagine that you have decided to see a movie and paid $10 for a paper ticket in advance. As you enter the theater you discover that you have lost the ticket. Would you still pay $10 for another ticket?

Although the value of the $10 loss in each scenarios is exactly the same, results show that 88% of people would buy another ticket in the first case, while only 46% would in the second.

It appears as if the loss in case 2 was already allocated to the movie experience account, and another $10 was considered too expensive. But in the 1st case it was just another $10 which had not been allocated to be spent anywhere else.  These results are inconsistent with the economic idea that money is all the same.

 

Real World Examples

Lets go through some cases where we may not always treat a dollar as a dollar;

  • Considering our tax returns or BAS refunds as bonus money to spend as we please, when it was our money all along.
  • Paying $10 for a beer on holidays, when we would complain about paying $6 at our local hotel
  • Spending time to get a $10 savings on a $100 fuel bill at the bowser, but not going to the same trouble to secure a $10 saving on a $1000 product.
  • Keeping a special savings account (earning little or no interest) when we have high interest debts
  • Going well over budget on large spend projects like irrigation or shed renovations because we think what’s another $1000 when the total bill is already high.
  • Spending more freely on credit than we would if we saw the cash directly leave our pockets or bank account

 

What to do

Sometimes there are great non-economic reasons to make these sorts of inconsistent decisions, like on a relaxing family holiday or planning your daughter’s wedding. But don’t fall into the trap of thinking you can’t or should not shop around.

Another key is to think of money in absolute terms and apply decisions consistently across all areas of investments, budgeting and debt repayment plans. Unexpected gains should be treated as normal income, and any related celebrations should be kept in the normal range of activities.  A trip to Vegas with your mates may be tempting, but probably not the best use of your hard earned funds.

Simple awareness that mental accounting can influence our judgements and decision making is a great first step to avoiding its pitfalls.

About the author:

Richard Wright: Fifo Capital 

(https://www.linkedin.com/pub/richard-wright/80/3b6/691)