When we mentally account, we earmark money to be spent for certain things ($100 for groceries, $50 for gas, etc). This leads to us making all sorts of wacky decisions that don’t make sense.

Consider the following scenarios presented to students in a study:

Scenario one: Imagine that you have decided to see a play where admission is $10 per ticket. As you enter the theater you discover that you have lost a $10 bill. Would you still pay $10 for a ticket for the play?

Scenario two: Imagine that you have decided to see a play and paid the admission price of $10 per ticket. As you enter the theater you discover that you have lost the ticket. The seat was not marked and the ticket cannot be recovered. Would you pay $10 for another ticket?

In the first scenario, 88 percent of the students said that they would buy a ticket compared to 46 percent in the second scenario. But yet if you look at it from a pure numbers point of view, the loss of $10 is exactly the same.

In another study, participants were asked to pick who they thought would be happier between Mr A. and Mr B.

Mr A. was given tickets to lotteries involving the World Series. He won $50 in one lottery and $25 in another.

Mr B. was given a ticket to a single, larger World Series lottery. He won $75.

Who was happier?
Results: Mr A: 64.4%, Mr B: 18.4%, No difference: 17.2%

Mr A. received a letter from the IRS saying he made a minor arithmetical mistake on his tax return and owed $100. He received a similar letter the same day from his state income tax authority saying he owed $50.

Mr B. received a letter from the IRS saying that he made a minor arithmetical mistake on his tax return and owed $150.

Who was more upset?
Results: Mr A: 75.9%, Mr B: 16.1%, No difference: 8.0%

Again, the outcomes of both scenarios were exactly the same.

How mental accounting mistakes cost us money

As a rule, people prefer their gains to be segregated and their losses to be integrated (or hidden). If companies are able to provide additional ways to segregate income, then consumers are more willing to spend on luxuries. We also tend to look at price differences relatively instead of absolutely.

That’s why:

  • The income tax system is designed to encourage people to receive refunds rather than pay additional taxes. As a result, people treat tax refunds as “free money” to blow when it was theirs all along! Casino and lottery winnings are treated similarly.
  • Premium products are marketed for special occasions (e.g. Beer commercial “Enjoy it with special occasions with friends and on weekends”) which set the stage for companies to market every day as a special occasion (e.g. “Every day is a weekend”).
  • We are treat investment gains and losses in separate accounts (e.g. TSFA, RRSP and trading or 401K, IRA, and trading) as different even though they all affect your net wealth. Gains in a portfolio will cause people to take on riskier bets because they are already up and net losses against winnings. People also tend to keep losses while selling gains to “lock in profits”.
  • A bottle of beer at a hotel convenience store costs more than a bottle of beer at a convenience store two blocks away
  • People will have no problem walking a block to save $5 on a $10 item, but will balk at the thought of walking a block to save $5 on a $500 item. The financial savings are exactly the same, but we don’t treat them this way. This is how the wedding industry makes off like bandits. What’s another $200 charge for flowers when the wedding is $10k?

This is also how construction and renovation budgets run over. Granite countertops for another $200? Sure! Fancy faucets for another $100? Of course! Before you know it, the $10k renovation has morphed into a $20k money pit.

What you should do about it

Treat all money as fungible. Think about things in terms of absolutes. Set absolute limits on what you are willing to do to save a certain amount. If you are willing to spend 30 minutes to save $10 on a $20 item, then you can do the same thing on a $1,000 item. Now this may seem a little ridiculous, but if you did this 200 times a year, that’s $2,000 in your pocket. Small purchases add up.

There is no such thing as “free money”. If you happen to come across more money than planned, treat it as you would your normal income and save it. If you really want to celebrate a bonus, do so, but celebrate as you normally would.

For example, let’s pretend you receive a $3,000 bonus at work that you weren’t expecting. Instead of spending the money freely on luxuries and things you normally wouldn’t buy, stick to things that you normally buy. Better yet, spend small amounts over time to maximize your happiness.

Pay attention to your income taxes. If you are making retirement plan contributions, fill out the appropriate forms to have the deductions taken off your income taxes throughout the year. You will not get the psychologically gratifying refund at the end of the year, but you will have more time to make use of that money. Invest wisely!

View your investment accounts holistically. Look at your asset allocations across all accounts. If you are invested in your employer’s stock, that amount should count towards your equity allocation in your portfolio. Similarly, if offered several mutual funds for your pension, look at the effect their additions will have on your allocations.

Resources

Thaler, R. Mental Accounting Matters. Journal of Behavioral Decision Making, 1999. http://faculty.chicagobooth.edu/richard.thaler/research/pdf/MentalAccounting.pdf

Thaler, R. Mental Accounting and Consumer Choice. Marketing Science, 1985. http://www.jstor.org/stable/183904

Tversky, T; Kahneman, D. The Framing of Decisions and the Psychology of Choice. American Association for the Advancement of Science, 1981. http://www.jstor.org/stable/1685855