Imagine this: you’re standing in line at movie box office to purchase a ticket. You reach into your pocket for the money but realize that you dropped the $20 bill you had set aside for the ticket. Do you dish out more money to buy a new ticket?
What if you already bought your ticket, but realize you lost it once you arrived at the theatre? Would you purchase another ticket or change your plans for the night?
Most people would be inconvenienced by either situation, but they still go ahead and watch the movie. Ask yourself, which scenario would sting more?
A study conducted by renowned psychologists Tversky and Kahneman discovered that only 46% of people who lost their ticket were willing to purchase a new one, but 88% who lost the equivalent amount in cash were still happy to go ahead with the purchase.
Why do most people feel differently about two economically equivalent scenarios? In both cases the economic loss is $20 but somehow losing the ticket hurts more compared to the cash.
Richard Thaler, professor at the University of Chicago and the 2017 recipient of the Nobel Prize in Economic Sciences, attributes this irrational economic behaviour to the mental accounting bias. His research shows that we keep separate accounts for different expense categories in our brain. When we lose the ticket we charge its cost to the superficial “entertainment account” in our minds, leaving less to spend on another ticket. However, cash is free from such scrutiny as it is not part of any distinct mental account. This is why most people find it easier to buy a new ticket when they lose cash.
Mental accounting violates the basic economic principle that money is fungible or interchangeable. It makes us look at economically identical choices as somehow different, often based on the source and the intent of each account. This can prove detrimental to our financial wellbeing as it affects how we spend, save and invest our money.
The source of the money matters. Research shows that we are more impulsive with money from unexpected sources. Casino winnings and tax refunds fall in this category, that’s why most people spend them on vacations and expensive dinners but not on hydro bills or paying off debt. Salaried individuals think about their bonuses in the same light. Although, bonuses are an extension of our compensation we tend to spend them more extravagantly compared to our regular paycheque.
We also label money based on our intent for each account. Many investors set aside an arbitrary amount of their capital for risky endeavours. They don’t mind losing money in this account as they think of it as “play money”. But is this money any different than the investments in their retirement account?
For investors, separating money into multiple accounts, each with its own purpose and asset mix can lead to risk tolerance imbalances. A good investment return in the retirement account is financially immaterial if the investor loses the same amount in the “play money” account. All the more, this exposes them to unnecessary risk without any financial reward.
We use mental accounting to keep our busy lives manageable. Separating money into subjective accounts simplifies and reduces the number of decisions we have to make each day. This is useful when we are dealing with immaterial and routine transactions on a day-to-day basis, but focusing on the micro level without paying attention to the big picture can lead us to ignore the bottom line in the long term.
To keep track of financial progress, investor’s should think about their financial situation holistically by assessing their overall asset mix, net worth and cash flow periodically. At Nexus, with the help of financial planning tools, we can help you organize different streams of income and savings in a logical order to ensure that you don’t miss the forest for the trees. MH