You've just decided to get yourself a new phone but you're faced with two choices - buying the more expensive version of the phone, or a slightly older version at a cheaper price.
After some reflection, you opt for the more expensive recent version, even though you know you won't use the latest software updates or features.
You have just fallen victim to mental accounting. A trick that advertisers and marketers use to get us to buy more. In this article, we explain what mental accounting is, how it affects our financial decisions and how you can prevent it.
It refers to a common but irrational financial decision-making process. The term explains how we tend to assign subjective value to our money, usually in ways that violate basic economic principles.
Thaler's work was heavily influenced by the work of Daniel Kahneman and Amos Tversky - two Israeli psychologists who had done extensive research on prediction and probability judgment.
Thaler believed that though the money had a consistent and objective value, the way we spent it depended on:
Thaler explained that we file money into different mental bank accounts and categorize them. These varied categorizations affect how we view money and eventually how we use them.
For example, we tend to label extra money we were not expecting as a “windfall gain.” As such, it is more likely that we spend our windfall gain extravagantly - something we would not do with our regular income.
Yet, according to Thaler, money is just money with the same value, regardless of how you got it. $1000 won in a lottery, or gotten through a weekly paycheck still has the same value.
Even though there is nothing different about money received unexpectedly compared to money from any other source, we feel like it’s special, so we feel justified in spending it extravagantly.
Here are a couple of reasons we do mental accounting
We tend to assign subjective labels to money.
When we do so, we fall victim to mental accounting. For example, we wouldn't mind paying extra for a can of soft drink at a movie or restaurant despite the fact we can buy the same drink at a less price from a convenience store.
This is because we have attached the label to the money we spent. We believe that it is expected to pay higher prices for basic goods when we are in places we consider classy or trendy.
Thaler calls this “transactional utility,” meaning we tend to value the merits of the transaction itself over the objective value of the thing being purchased.
Another reason why we fall victim to mental accounting is how we perceive losses and gains.
Let's consider this scenario: Mr. A wins $500 in one lottery and $250 in another, while Mr. B won $750 from a single ticket. Most likely you would say Mr. A is happier than Mr. B, even though they both won the same amount.
However, the opposite is true for losses. Let's say Mr. A loses $1000 and later that same day, he loses another $500. Meanwhile, Mr. B losses $1500 at a go. Again, the amounts of money lost are the same; and yet, the majority of people believe Mr. A would be more upset by these events.
The above scenario illustrates how we tend to see gains and losses. It shows that we respond very differently to money depending on how things are presented.
Mental accounting alters our perception of money, making it easier for us to overspend.
In research carried out by Kahneman and Tversky, participants were instructed to picture themselves ready to spend $15 on a calculator and $125 on a jacket. The calculator salesperson then tells the customer that another retail location is selling the same calculator for $10.
68% of those surveyed said making the commute would be worth saving $5 on the calculator.
With another group of participants, the question was altered: the calculator cost $125, and the jacket $15. Customers could get the calculator at the other branch for $120. However this time, only 29% of respondents said they would make the trip.
In both scenarios, though the amount being saved is the same, participants preferred to save $5 when the item looked 'cheap' because the amount saved was looked on as 'more', (i.e. saving $5 from $15).
However when the cost was higher, saving $5 looked 'small' (i.e. saving $5 from $125). This illustrates that the value we attach to a thing frames our financial decision-making.
When it comes to setting budgets, mental accounting can lead us astray by having us think in terms of separate accounts, rather than considering our financial situation holistically.
For example, one might have a mental “coffee” account, for which we mentally budget a certain amount each week for a daily latte from Starbucks. However, if you decide to make your coffee at home, it would save you more money in the long term.
Mental accounting contributes to the sunk cost fallacy—the tendency to continue with a behavior for longer than we should, because we feel like we need to make our initial investment “worth it.”
For example, let’s say you’ve spent $100 on a concert ticket.
On the day of the concert, there is severe weather which makes it difficult and unpleasant to get to the venue. In this situation, many people would feel compelled to make the trip because it would feel like the $100 has been “wasted.”
In reality, the $100 is a sunk cost ie. it is spent, and no matter what you do, you will still be out $100.
If the costs of getting to the concert venue are greater than the pleasure you will get from seeing the show, then at the end of the day, going will result in a worse outcome than staying home.
Here are a few ways to avoid mental accounting bias
Making a list of all your costs and the amount you would want to spend in each area might be useful instead of just keeping track of your spending mentally. You might be able to view your financial condition differently if you put numbers to it.
Treating windfalls as "free money" may not seem like a huge problem at first, but if you keep track, you could find that the money builds up more than you first expected.
Make a strategy for unexpected income, such as gifts, tax returns, and bonuses etc.
For instance, you can opt to divide your next windfall three ways rather than spending it all on an impulsive shopping binge. Spend a third on debt repayment, a third on savings, and the remaining third on a reward for yourself.
Identifying your financial priorities helps counter mental accounting.
It gives clarity on what you should be spending your money on regardless of how you got it. This way you can always put money to good use.
Mental accounting can skew our impressions of money. It can cause us to make decisions about how much to spend intuitively rather than rationally.
Fortunately, you may avoid making these mistakes by making a serious effort to break these unhealthy financial habits.
Being purposeful with your money is the greatest way to prevent mental accounting. Consider your spending patterns carefully and ask yourself openly if there is an opportunity for change.
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