Mental Accounting: Why Smart People Make Big Money Mistakes
A lot of you have asked for more posts on investor psychology (articles, links, books), including mental accounting, anchoring, and cognitive biases that affect our investing.
Today’s post on mental accounting is by Claire, who holds an MBA and other degrees from Stanford and Oxford.
Belsky and Gilovich have a big job ahead of them. In only 215 pages, they want to explain to you why you’re an idiot. Sometimes.
Promising to give you “lessons from the new science of behavioral economics,” Why Smart People Make Big Money Mistakes was right up my alley. I love learning about the motivations behind spending, saving, and doing dumb stuff with money. This book promised to answer some of those fascinating money questions. Why are so many of us willing to spend so much more for a product bought on credit than with cash? Why do business executives spend ever-increasing amounts of money on failing products or money-losing corporate divisions? Although originally written in 1999, the book holds a wealth of wisdom for all time.
Learn Mental Accounting:
Behavioral economists say that mental accounting works like this: let’s say you have bought a $150 ticket to a concert. When you show up at the door and realize you have lost your ticket, do you buy another? Probably not.
But let’s say you hadn’t bought the ticket yet, and you show up at the door of the concert hall to buy your ticket. Unfortunately, you realized you’ve lost $150 in cash since you walked from your car. LUCKILY, you still have enough in your wallet though to cover the cost of the ticket. Do you buy the ticket? Yes.
Why?
Both scenarios are a loss of $150. However, in the second scenario you separate the losing of the $150 from the purchasing of the ticket. In the first you consider the cost of the event as a total of $300 and retch at the high cost.
It turns out that Mental Accounting is a huge contributor to the low rates of savings in the US (in 1999 it was 4% in the US and over 15% in Japan).
When Do You Use Mental Accounting?
How can you know if you are more likely to be affected by mental accounting? Here are some clues:
- You don’t think you spend, but you have trouble saving
- You have savings in the bank, but your credit cards aren’t always paid off
- You spend more with credit cards than with cash
- You’re more likely to spend your tax refund than your savings on a new itouch
Things You Should Know about Mental Accounting:
- We have a tendency to value money differently depending on where it comes from. If you win $50 in the lottery – considered “found” money – you more likely to spend that on garbage than the $50 you earned on the job. If you get tax refund – you’ll run out and spend it instead of saving.
- We are victims of the concept of “relative cost”. You want to spend $10,500 dollars but the used car dealer says it’ll be $500 extra this time of year. Mental accounting tells you that $500 in compared to the cost of the car isn’t that bad. But you want to buy a washing machine for $500 – you show up and they say it’s now $1000. Do you buy it? No. Mental accounting tells me that’s crazy talk.
- Plastic equals fake money:It sounds like the oldest most overused money trick but it still holds true – people do spend more with credit cards. When the weight of your wallet doesn’t change, you are less likely to think you’ve really spent anything.
How can you fix the problem of Mental Accounting?
- Do what the book says: “Imagine that all income is earned income.” You worked for granny’s xmas check, so don’t waste it.
- Pretend you don’t have the plastic. Although Belsky and Gilovich haven’t gone all Dave Ramsey on us and told us not to use credit cards, they are saying we should stop and think: would I buy this if I was using cash?
- Use mental accounting to your advantage by automatically funneling money out of your paycheck (Ramit does this, and has told you to follow suit)
- Remember that money is money. $3,000 more on a $200,000 house isn’t less money than $3,000 more on a $3,000 dining room set.
- Record keeping is the key to success – I’ve always claimed this, and this book enforced this more than anything. (Yes, we’ve regressed back to Ramit’s dreaded David Bach latte factor.) Little things can add up. $10 a day in extra soda, gum, magazines and lunch out is $3,500 bucks a year.
Did I like it?
Oh yeah.
Will you like it?
If you want to learn about your mind, and not crunch numbers, you’ll get a kick out of it. Heck, win it here.
Take away point?
Money is money is money. Your mind, however, can be on crack.
Claire is an author of the upcoming book, Over-Choiced, and has been featured in such publications as Business Week and The Huffington Post, and at her money-saving blog, Choyster Cash. Get “Why Smart People Make Big Money Mistakes” on Amazon.
