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OPINION27 October 2015

Bias in the spotlight: mental accounting

Behavioural economics Finance Opinion

The concept of mental accounting, first identified by the economist Richard Thaler, shows how we have a natural inclination to organise, evaluate and keep track of our finances.

We categorise, compartmentalise and treat money differently depending on where it comes from, where it is kept, or how it is spent.

In its simplest form, mental accounting is about considering how people think about money by trying to understand the psychology behind spending and saving and examining how individuals and households organise their money.

Early in the 20th century it was a little easier to organise our money than it is today. Most people were paid cash in hand at the end of each week so it was a straightforward task to allocate money for different purposes. Actual ‘jam jar’ accounting was often used. In the early 1920s a housewife explained her system to a publication called Women’s Home Companion:

“I collected eight little cans, all the same size, and pasted on them the following words, in big letters: groceries, carfare, gas, laundry, rent, tithe, savings, miscellaneous.… [W]e speak of those cans now, as the grocery can, carfare can, etc.”.

This is a positive use of mental accounting, earmarking money for different purposes to help us to budget, organise and keep track of our money efficiently. There are also other positive uses:

  • Controlling spending by creating physical barriers: Physically splitting money up, separating it into different physical accounts also creates a barrier to spending. For example, it might be a hassle to transfer money out of our savings account or there might be a penalty charge for doing so.
  • Controlling spending by creating mental barriers: At a psychological level, once money is separated out and designated for a particular purpose, we may feel committed to that designation and reluctant to change that. For example, we might be reluctant to spend money we have already mentally allocated to paying our rent or buying a new car. So mental accounting is a useful method of controlling spending to make sure we will have enough for necessities like bills or in order to save for specific goals.

Negative impacts

However, mental accounting also means we may behave in sub-optimal ways. Whereas rational behaviour treats a pound as a pound, wherever it comes from, most people have a tendency to treat money differently depending on where it comes from. For example, ‘found’ money will tend to be regarded differently from earned money. So we might well spend gains, particularly unexpected gains, from gambling wins, bonuses, inheritances and other gifts in a different way than we spend money we have earned – our monthly salary or savings:

  • Worthy spending of sentimental money: We often treat money differently when it derives from a sentimental source. For example, it seems wrong to many people to use a sum of money that has sentimental origins, perhaps given to us by a close relation who has passed away, to pay off debt, pay bills or even invest it in high return stocks. We often want to do something significant or memorable with it, perhaps use it to fund a holiday of a lifetime or to set up a charity.
  • Profligate spending or gambling of money won: We often tend to spend ‘won’ money – money we did not expect to have; such as a gift, or tax rebate or prize win in a very hedonic or profligate way. For example, people are much more likely to gamble with money they have won than money they have earned or inherited.

Simultaneous borrowing and saving

Mental accounting means we also have an aversion to using savings to pay off debt. We might have a costly loan or credit card debt on which we are paying high interest rates, despite holding savings which could pay off part or even all of that debt. For example, one study of US households found that 90% of credit card borrowers simultaneously hold savings and a third of those carrying a credit card also had over one month’s worth of income in savings. Another US study found that almost one in five people who took out high cost loans such as payday loans did so without fully emptying their savings.

Finally, while earmarking money into different accounts for different purposes has numerous benefits, sometimes they can be too rigid. This flaw in mental accounting is perfectly illustrated in this scene from US TV series Curb Your Enthusiasm, where the show’s protagonist Larry has just received an invitation to friend Simon’s lavish birthday party. Larry, recalling that he lent Simon $10,000 a month ago, decides to challenge Simon on his mental accounting… Simon’s rigid earmarking of the money leaves Larry feeling miffed!

Crawford Hollingworth is founder of the Behavioural Architects