Mental Accounting, and the jars of money in our head
The term ‘Mental Accounting’ was coined by behavioural economist Richard Thaler and describes the inclination to categorise and treat money differently, depending on where it comes from, and how it’s spent.
In his book Nudge, Richard Thaler tells the story of Dustin Hoffman and Gene Hackman, who in their early days, were struggling actors trying to pay their bills.
On one particular day Gene Hackman was visiting Dustin Hoffman’s apartment. Soon after arriving, Hoffman asked Hackman for a small loan of $5. Hackman agreed, but then went into the kitchen to find a row of jars filled with money on the kitchen ledge. One jar was labelled ‘Rent’, another ‘Entertainment’, and another ‘Books’ and so on. Hackman asked Hoffman why he wanted a loan when he had all this money. Hoffman answered by pointing to the food jar, which was empty.
The story perfectly illustrates Mental Accounting, which is the ‘home’ equivalent of financial accounting. It’s where people create spending accounts in their head, with implied budgets for activities such as entertainment, travel and clothing. If there’s an overspend in one area, mental accounting will stop purchases in that area, but happily continue spending in other areas.
We use mental accounting for the purposes of self-control, but sometimes there is a cost for this self-control.
The Quirks
Though many people use Mental Accounting, few realise its logical deficiencies.
In one particular study it was found that if a person buys a $10 movie ticket and then loses it, only 46% of people would replace the ticket. However, if a person loses $10 of cash before buying the ticket, then 88% of people said they would still buy a ticket.
The reason for this, is that losing $10 cash is seen as a loss to the ‘overhead’ account, whereas losing a ticket and buying another ticket, takes $20 from your entertainment account, which feels expensive.
Another quirk of Mental Accounting is that people may have money saved away in a low interest savings account for a holiday, while still carrying substantial high-interest credit card debt.
Mental accounting also explains how we spend our tax returns. While our salary is normally used to pay our daily bills, a tax return is seen as a bonus or ‘found money’. Thus, people feel free to spend it on discretionary items such as a new TV.
House Money
Another example of Mental Accounting is the ‘House Money effect’ which gets its name from the phrase ‘playing with the house’s money’. Its premise is that people are more willing to take risks with money that they have obtained easily or unexpectedly, in an ‘easy come, easy go’ fashion.
The easy money may come by way of gambling, winning a competition, the sale of a house, a highly profitable stock trade, or an unexpected inheritance.
In stock markets, the House Money effect can be seen after a highly successful trade, where traders often use their winnings to buy more high-risk stocks. The effect was seen during the dotcom bubble, where traders who had seen their stocks rise by multiples, would then use that money to buy into the next hot stock, hoping for similar success.
This effect contrasts with the way people deal with ‘hard earned cash’, where there is often a hesitancy to buy risky stocks. The reason for this is that the person knows the work that’s gone into earning that cash and they don’t want to lose it.
Even though the way we treat house money and hard-earned cash can be quite different, the reality is that they’re both the same, in that they are still money.
When it comes to house money, we should always think of it as the same as hard earned cash. And in that way, it will cause us to use it wisely.
Summary
Budgeting is a great thing to do, but we must be aware of Mental Accounting. Here are four ways we can do so:
- Remember that every dollar we own, is the same as every other dollar we own.
- Always think of ‘easily won’ cash, such as bonuses or tax returns, as the same as hard earned cash.
- If you have a highly successful stock trade and want to cash out, don’t put your winnings into other risky stocks. Rather, buy low-risk ETFs or Managed Funds to ensure your money is preserved.
- If you have low-interest savings but also a high-interest credit card balance, consider paying off your credit card balance with your savings. This will help remove your high-interest credit card costs. Once this is done, then continue saving.
Every dollar counts. That's why InvestSMART Diversified Portfolios have capped management fees keeping more of your investment compounding and growing your wealth. Use the chat in the bottom right to talk to our team about our portfolios.
Frequently Asked Questions about this Article…
Mental accounting is a concept introduced by behavioral economist Richard Thaler, describing how people categorize and treat money differently based on its source and intended use. This can lead to irrational spending habits, such as overspending in one category while being frugal in another.
Mental accounting can lead investors to take unnecessary risks with 'easy money' from successful trades or unexpected windfalls, while being overly cautious with 'hard-earned' money. Recognizing this bias can help you make more balanced investment decisions.
People often view tax returns as 'found money' because they see it as a bonus rather than part of their regular income. This perception can lead to spending it on discretionary items rather than saving or investing it wisely.
The 'House Money effect' refers to the tendency to take greater risks with money that is perceived as easily obtained, such as from gambling or a successful stock trade. This can lead to riskier investment choices compared to money earned through regular work.
To avoid the pitfalls of mental accounting, treat all money equally, whether it's a bonus or regular income. Consider using successful trade profits for low-risk investments and pay off high-interest debts with savings to optimize your financial health.
Treating 'easy money' the same as 'hard-earned' money helps prevent impulsive spending and encourages wise investment decisions. Recognizing that all money has the same value can lead to better financial outcomes.
Mental accounting explains this reluctance because losing a movie ticket and buying another feels like a double expense from the entertainment budget, whereas losing cash is seen as a general loss, making it easier to justify buying a new ticket.
To manage finances better, remember that all dollars are equal, treat bonuses like regular income, invest wisely rather than taking unnecessary risks, and prioritize paying off high-interest debts before saving in low-interest accounts.