Do you remember getting loads of cash on your birthday from relatives along with cards from your friends? The majority of us, I assume, used to rush out to the mall the very next day and spend it on an item that we wanted to purchase for a long time, but never wanted to spend so much money on that item. People may severely judge how you spend your ‘job income’, but no one bothers how you spent your one-time ‘birthday pay off’. Before diving deep into what is mental accounting, let’s study some examples.
In the above example, the reality is that this birthday money is in no way different than your regular job income, or investment returns, perhaps. If your house loan installment needs to be paid, there’s no logic in thinking that ‘why do I use my birthday money in paying it?’.
Let’s take another example. Bonuses can be referred to as an adult version of birthday money. Have you ever noticed that employees spend their ‘bonus’ on things which they won’t be able to justify, like a lavish vacation or a new car? What I mean is that if your current finances already allow you to spend extravagantly, then a bonus may serve as an icing on the cake! However, on the contrary, where your finances aren’t sufficient enough that you make irrational purchases, then a ‘bonus’ or a ‘birthday gift’ should not change that fact. For example, consider you’re a frugal person, however, if you find Rs. 1000 on the street, and you’re saving some amount to buy a car. Chances are that you might spend that Rs. 1000 on an expensive dinner and treat yourself than save it for the car, because you treat it as separate, unexpected money based on its source (picking it up from the street), and thus spend it differently.
This refers to mental accounting bias. Also known as the ‘two pocket theory’, this bias occurs when people put their money in separate categories or different mental accounts based on the source of that income, which in turn affects their decision to spend it.
Classic Theatre Problem:
Case 1: Imagine you had a plan of watching a movie tonight and you had already purchased a ticket of Rs. 100 for the same. As you enter the movie hall, you realize that you’ve lost the ticket. You need to purchase a new ticket to watch the movie. Would you pay Rs.100 for another ticket?
Case 2: Imagine you make a plan of watching a movie and go to the theatre, and the ticket costs Rs. 100. Then you realize that you’ve lost Rs. 100 on the way. Would you still pay Rs.100 for the ticket?
This is the Kahneman and Tversky experiment done in their research paper. Out of the 200 people surveyed, in the first case, 46% said ‘Yes’ and 54% said ‘No’. While in the second case, 88% said ‘Yes’ and 12% said ‘No’.
Isn’t this shocking? People are willing to spend even if they lost Rs.100 in cash, while they become unwilling to spend if they lost Rs.100 as a ticket. This is because of people forming a separate ‘mental ticket’ account. If they have to buy another ticket for Rs.100, they perceive it as a loss of Rs.200.
Why does mental accounting bias take place?
One of the major properties of money is that it’s interchangeable and indistinguishable. This is known as fungibility, a rupee is the same no matter what is its source or how is it spent. This means there are no labels on money i.e. the same money can be spent on coffee or buying a bus ticket.
However, we tend to treat money less fungible than it is. Many studies have shown that people tend to categorize their income mentally into ‘regular income’ and ‘windfall gains’ and people are more likely to spend the latter more, and that too on luxury goods. Even though there’s nothing different about the money we received unexpectedly versus our regular income, we still feel the former is special, so we justify acting as an irrational consumer and spending it extravagantly.
Let’s take the example of a tax refund. When you receive this refund, people mentally perceive it to be a gain and spend it on a discretionary item. But here, the money rightfully belonged to the person in the first place. It is a restoration of money, not a gift.
Problems with Mental Accounting:
The major problem with mental accounting is that it gives us a narrow view of our finances. It may blind us and we might not be making the optimum use of that money, which we could have invested somewhere else, perhaps. For example, if a waiter receives a ‘tip’, he may see it as ‘free money’ and exempt it from the rules he follows while spending his regular income. He may not use that tip money in paying his bills, which in fact should have been his priority.
It misleads people and forces them to make unwanted choices, just to avoid losses. Let’s take another example. If you have already paid for a concert ticket, but on the day of the concert, it starts raining and there is a lot of traffic jam, in short, it’s a mess, so much so that it even changes your mind to go to the concert. But the majority of people will still go, as the mental accounting theory suggests. It explains that when people buy a ticket in advance, they open a mental ticket account and overdraw Rs. 100, for example as the cost of the ticket. You feel that going to the concert is the only way of closing that account and balancing it. However, what people don’t realize here is, that if the cost of going to the concert is more than the pleasure you are deriving from it, it’s an ultimate loss.
Another disadvantage is that people usually keep a lot of money as emergency funds, which they could alternatively invest and earn a return on. All these examples show sub-par financial decisions, either refusing to spend the earmarked money on necessities or spending bonuses as lavishly as possible.
The unsung benefit of mental accounting:
Probably the only and the greatest benefit of this bias is that it leads to the creation of an emergency fund, which can be utilized in unfortunate times like the untimely death of a family member, or case of unemployment or retirement also. The same bias which forces you to make bad decisions also keeps you from spending assets that you may require at a future point of time when the need will be probably greater than what it may be today.
How to avoid mental accounting?
The majority of the investors today suffer from mental accounting bias, but we should all ask ourselves, whether it is harming us or helping us?
There are very few people who use it to their advantage. If you’re not one of them, make yourself understand the fundamental principle of fungibility of money, first.
Secondly, there are a large number of financial planners or accountability professionals ready to help you. I think it’s time we let go of our notion of not talking about our money with someone else, and considering it as a taboo; that’s the only way we can get ourselves out of such bias traps.
Read other articles in this Finance series: