Outline:
- You are mental accounting when you treat money differently depending on where it comes from and what you want to use it for;
- Acknowledging this behaviour will allow you to shift your financial habits.
A blissful newlywed couple head to Las Vegas for their honeymoon where they promptly shred the tables. In a fit of matrimonial frenzy, they pour money into pokie machines, blackjack tables and try their hands at poker.
Their fervor is so great that in less than 72-hours, they’ve completely run out of money and are forced to cut their honeymoon short. Dolefully, they head to their hotel suite. The wife slips off to sleep while her husband stares around the room.
His gaze falls on a five dollar souvenir they bought upon their arrival, and a premonition assures him that the number 17 will bring him great fortune.
Within minutes, he’s sold the souvenir and is back at the roulette table, putting the five dollars on 17. His luck turns in an instant, and an explosion of good providence sees him winning thousands of dollars, then millions, then tens of millions and then more than $100 million.
He announces to the room at large that he intends to cap off his riches by placing the entirety of his $100 million on one number. A clerk tells him the casino can’t cover this bet but is happy to escort him to a larger casino that can.
A limousine ferries him to another property and, surrounded by bodyguards and curious onlookers, he places his $100 million on 17. Of course, the ball lands on 30 and the house regrettably informs him he’s out of money.
The man is forced to walk back to his hotel room where he is greeted by his irate wife, demanding to know how much more money he’s lost at the casino. Tiredly, the man gets into bed and tells her: “Five dollars. I lost five dollars.”
Does that sound right?
Mental accounting refers to the practice of treating money differently depending on where it comes from and what it’s used for.
Most people do it with their credit cards: once their juicy paycheck comes through, they pay off their credit minimum and allocate more towards their savings or their holiday fund.
That’s despite the fact that credit debt costs more than savings interest earns.
It’s bad economics, but seems to make sense to the vast majority of people.
Separating money into different “pots” is a characteristic Australians are taught young. Put a little bit aside for a new gameboy and a bit more away for your first car, and over time you’ll have enough money to cover all your bases.
But when we introduce the cost of servicing debt, or even when we unexpectedly receive money (think a Lotto win, work bonus, birthday money), our behaviour sometimes changes in such a way that actually leaves us financially worse off.
“Money is always fungible,” warns Parag Parikh, the late director of PPFAS Asset Management and world renowned value investor.
“Whether you find it, win it, earned as salary or as tax refund. All money has the same purchasing power, irrespective of how you got it. There is no such thing as special money for different things.”
Share traders often suffer from mental accounting. They might begin with $20,000 and, thanks to diligent research, fortuitous business cycles and more than a dollop of good luck, they successfully manipulate it to become $100,000.
But when the market turns and their portfolio wipes out, they’ll often only bemoan the loss of their initial $20,000 investment, not the fact they once had access to the entire $100,000.
The hedonic editing hypothesis.
Richard Thaler - the most recent winner of the Nobel Prize for Economics - says people try to frame outcomes that make themselves as happy as possible.
Source: Forbes.
He calls this the “hedonic editing hypothesis”. We maximise value by mentally segregating or integrating outcomes depending on which mental representation is the most desirable.
We like to see our holiday balance going up, rather than note our debt balance is going down. An unexpected work bonus prompts us to splurge on Prada, rather than see it as cash that could earn us dividends through a reliable, blue chip stock.
(Having said that, there is no need to be a miser. Prada can be wonderful.)
Research has found (over and over again) that share investors aggregate their losses (sell their bad positions on the one day) and segregate their wins (stagger them out so they appear more lucrative). In the case of our trader, he saw the $80,000 he earned on his trades as prize money, or gift money, or even untouchable, remote money, which allowed him to swallow the fact that it’s been lost.
Many early cryptocurrency adopters who lost hard drives or who had their keys stolen, like to tell themselves they haven’t actually lost anything because they don’t feel like they ever had anything. But of course, they would feel differently if they had the equivalent of their holdings in cash on their living room floors.
Another example is the colourful character who is placing TAB bets at a packed cricket match.
After a morning of alternatively shouting at the disappointing batsmen and his smartphone app, he lets off steam by having a furious argument with the ice-cream seller. He is irate the seller has the audacity to charge $8 per cone, when everybody in the stadium knows you can buy one outside for $3.
The seller shrugs, leaves and the man continues his betting into the afternoon. Not long after lunch, whoops of delight are heard echoing around the stands, and to the surprise of his closest neighbours, the man orders the ice-cream seller to return.
In a jubilant fit, he buys ten ice-creams and hands them out to those around him, celebrating the collapse of the afternoon’s batting order.
Once you know it, you can change it.
Mental accounting is an inherently human habit, and this man shows a startling change of mind when he has access to more money. Suddenly he could afford the exorbitant ice-cream price and his original rationale goes out the window. The cash, which he has segregated into “winnings”, was easier to spend than the money he had probably earned throughout the week at his job.
The upside is, the minute you acknowledge this human habit of mental accounting, new clear-eyed perspective will open up for you.
Paying down debt quickly, will enable you to save faster over the longer term, because you won’t be slugged with debt fees. Taking a minute to acknowledge you actually have $80,000 extra in your portfolio, might prompt you to exit your position earlier than your risk tolerance allows, but will ultimately give you access to more money.
Thinking back to our hysterical newlyweds who gambled all their money.
At one point, they had access to $100 million, but because one of them was prone to mental accounting, he allocated his winnings to prize money, casino money, gift money, definitely not his money, and as such, his brain tricked him into behaving in a way that jeopardised his good fortune.
He lost $100 million that night because a dollar is a dollar is a dollar. Even if it’s easy to get, it’s just as powerful as the dollars that you work hard for.
Presumably, the next question is how much will both of those gamblers will lose in the divorce.
