As Piotr Łabuz, a psychologist, trader and financial mentor, explains: ‘Mental accounting is a mechanism by which we code and control where we get our money and what we spend it on.’ Depending on how earnings or expenses are processed by our mental accounting, we manage money differently. That’s why we’re less prudent with money that is gifted or won in a lottery than earned through hard work. People who come into money by winning a jackpot or getting a huge inheritance usually lose it quickly...
In addition, we’re masters of ‘creative accounting’, especially when vacationing. While on vacation, we’re prepared to spend much more on an indulgent scoop of luxury ice-cream, restaurant meals or entertainment than at home because our mental accounting system classifies such expenses as ‘vacation spending’ rather than ‘daily living costs’. Interestingly, the mechanism also applies to people living in popular tourist destinations.
In the 1980s, American economist Richard Thaler was the first to describe the phenomenon of ‘mental accounting’ which contradicts the principles of classical economics and rational choice theory. According to Thaler, people budget money into separate ‘mental accounts’, that is ‘slots’ into which different expenses and resources are categorized. This can be compared to the work of a real accountant recording incomes and expenses as debits or credits. The purpose of this mental categorization is to feel more in control of your finances and manage different types of incoming and outgoing money.
During financial coaching sessions, I work with my clients by analyzing their spending patterns, but also getting insights into their approach to money in general, and the ways in which they do their mental accounting. Crucially, if you want to manage your finances better, you need to change not only your bad habits, but also underlying beliefs and ways of thinking.
Because of mental accounting, people may have a completely different approach to money management in their private and professional life despite the same underlying personality traits, financial knowledge and competencies. Probably everyone knows people who manage their own budgets very carefully, but at the same time spend corporate or public money like water. And vice versa: there are people who prepare meticulous statements of revenues and expenses for their company, while being very bad managers of their household budgets.
Many psychological experiments have shown that people make financial decisions inconsistently. For example, imagine that you want to go to the theater. You pay PLN 100 for a ticket, but then you lose it. You’re unlikely to buy a new ticket, because you’ve already recorded this expense under ‘I’ve used up the entire budget for the theater this month’. Now imagine that you lose PLN 100, but you don’t have a theater ticket yet. You’re not any less likely to buy one because the loss of PLN 100 hasn’t been recorded specifically under ‘theater budget’’ in your mental accounting system. Even though the two scenarios are similar, and the loss is PLN 100 in both of them, you take completely different actions.
Customers in restaurants are often outraged when a 5% service charge is added to their check, even if they always tip the waiters at least 10%. In the former case, the extra 5% is recorded as an ‘imposed surcharge’, while in the latter it represents ‘an independent decision to say thank you for a good meal’.
It’s worth knowing that mental accounting can be a trap leading to irrational decisions. The mechanism is often used in sales and marketing. Advertisements and stores tempt us to mentally reassign money and buy their wares. If expensive cosmetics are categorized as ‘because I’m worth it’ rather than ‘unnecessary luxury’, you are more likely to buy them.
But there may be more serious financial consequences as well. For example, many people having PLN 10,000 deposited in their bank at an interest rate of just 5% per year tend to take a short-term loan also for PLN 10,000 despite having to pay an interest rate of 15% per year. A more reasonable solution to get PLN 10,000 would be to withdraw money from the low-interest deposit instead of taking out an expensive loan!
Another example is the different approach of many investors to spending profits from their shares. “Winnett & Lewis (1995) noted that the propensity to spend earnings is higher when they come from dividends than when the stock price rises by the same amount. So investors treat profits from dividends differently than profits resulting from share price increases.”[1]
Importantly, mental accounting has two basic principles:
Distribution of profits
People feel a greater sense of pleasure from multiple small profits or rewards than a single bigger one. For instance, you feel happier after getting two pay rises of PLN 250 than one PLN 500 pay rise. Or you have a greater sense of satisfaction when you go to a restaurant twice and pay PLN 150 each time than when you go out only once and spend PLN 300. This mechanism also applies to receiving gifts. Three small gifts usually give more joy than one gift at a total price equivalent to those three. Children in particular are happier after getting a few cheaper toys than a single very expensive one. You can read more about gift-giving in my article How to spend money to be truly happy?
Integration of losses
One big loss is less upsetting than several smaller losses. For example: one bigger price increase is easier to swallow than two smaller price increases in a row, even if they make up the same amount. And if you lose PLN 5,000 on the stock exchange in a single transaction, you recover faster than after having two losses of PLN 2,500 twice in a short time. If you lose money once, you tend to rationalize it as a random event, without losing belief in your capacity as an investor. If you have two losing trades, rationalization becomes more difficult.
It may also happen that you mentally frame a gain as a loss, and instead of joy, you feel resentment! This is the case when, for example, your boss promises to give you a pay rise of PLN 500, but in the end gives you only PLN 200. Even though you end up getting PLN 200 more, it’s a good bet that you’ll feel more offended than grateful. On the other hand, if your boss promises you a pay rise of PLN 200 and you actually get PLN 200 extra, you feel happy. That’s why it’s better not to make untenable promises. Instead, try to pleasantly surprise people with a bonus, a favor or a faster delivery, without doing something extra but below what was originally promised.
Everyone falls prey to cognitive biases in reasoning. We don’t always make rational decisions. So it’s good to know the pitfalls we fall into and why it happens, and gain greater awareness of our beliefs and thinking patterns.
[1] “Księgowanie mentalne i jego konsekwencje” (“Mental accounting and its effects”) Piotr Zielonka, https://skarbiec.biz/inne/home-klitomsl-public_html-121-skarbiec-wp-content-uploads-skarbiec-domy-maklerskie-mentalne-htm.html
