Mental Accounting and Your Money
“Mr. and Mrs. L and Mr. and Mrs. H went on a fishing trip in the northwest and caught some salmon. They packed the fish and sent it home on an airline, but the fish were lost in transit. They received $300 from the airline. The couples take the money, go out to dinner and spend $225. They had never spent that much at a restaurant before.”
“A bonus or refund cheque is money you’ve earned. It’s not a gift from god…. A credit card needs to be paid. It is not a gift from a rich uncle….”
Mental accounting, also known as “two-pocket” theory, is a behavioral bias that occurs when people put their money into separate categories, separating them into different mental accounts, based on, say, the source of the money, or the intent of the account. In the first quote above, according to Thaler (2008), the $300 bills were labeled as “windfall gain” and put into “food” accounts.
Game: Classical Theater Problem
- Case 1: Imagine that you have decided to watch a movie tonight and you already purchased a ticket for $10. As you enter the theater, you discover that you have lost the ticket. The ticket office tells you they keep no records so you will have to purchase a new ticket to see the movie. Would you still pay $10 for another ticket?
- Case 2: Imagine that you have decided to watch a movie tonight and the ticket is $10. As you enter the theater, you discover that have lost $10 bill on the way. Would you still pay $10 for a ticket for the movie?
This is the Kahneman and Tversky (1984) classical theater ticket experiment (click here to get the full article). In their paper, 200 participants participated in the experiments. In the first case, 46% replied “Yes”, and 54% replied “No.” Meanwhile, in the second case, 88% said, “Yes,” and only 12% chose “No.”
Okay, that’s insane.
Why are people so much more willing to spend $10 when they lost $10 in cash, versus when they lost a $10 ticket? The answer is that people have a mental “movie ticket” account and when they have to buy a second ticket, they impute a total cost of $20 to the aggregate movie ticket transaction, and this is perceived as too much. The loss of cash, however, is perceived at the portfolio level of net worth, which is independent of the mental movie ticket account.
Applications in Finance:
Mental accounting and risk taking
Although they shouldn’t be, equity investors and casino gamblers are affected by mental biases. We hear stories about lottery winners who go broke despite winning millions of dollars, and big winners at casinos who keep gambling and end up losing it all and more. Lotto winners are inclined to engage in more impulse spending because they mentally account the gains as “unexpected profits,” whereas, had they earned their profits via their day job, they would be less inclined to spend wildly. Lotto winners are willing to take more risks with unexpected gains, based on the “house money” effect. A study about how tax refund checks can boost consumption shows that average consumers will spend an additional $4,500 even when they received only a $1,800 tax refund (Click here to read the full article). This excessive spending is based on perceived gains in a “windfall” account.
Similarly, investors take different risks with money depending on its source. Money obtained from earning a salary and money associated with capital gains are treated differently. Capital gains make investors willing to enlarge their “affordable loss” level (how much they are willing to lose). Money that you earn by working may be more valuable to you, perhaps due to the trophy effect. Your mental biases may lead you reach conclusions about value inconsistently and irrationally.
Mental accounting and portfolio management
Money is fungible. Any dollar is exchangeable and substitutable for any other dollar, no matter its source or how it was obtained. Yet, due to mental accounting, we sometimes fall victim to so-called “fungibility violations,” when we treat some dollars differently from other dollars. When managing a portfolio and striving for diversification, scrutinize it for fungibility violations driven by mental accounting.
How to Spot the Fungibility Violation?
Here is an example from Thaler (2008) paper:
“Mr. and Mrs. J have saved $15,000 toward their dream vacation home. They hope to buy the home in five years. The money earns 10% in a money market account. They just bought a new car for $11,000 which they financed with a three-year car loan at 15%.”
Mr. and Mrs. J have effectively borrowed $11,000 at 15% and are reinvesting it at 10%, structurally locking in losses of 5%.
For example, if the couple simply took $11,000 from their $15,000, the cost of that $11,000 is the opportunity cost they forego, which is 10%–the amount they would have earned in the bank account–however, by taking out a loan of $11,000 at 15%, they investing $11,000 @ 10% in the bank account, “saving” for the house, and simultaneously borrowing 11,000 @ 15% to buy the house. On net, they are locking in a 5% cost on $11,000.
Focus on your entire portfolio; deploy capital optimally; and avoid burning money due to mental accounting!
- Richard H. Thaler (2008), “Mental Accounting and Consumer Choice”, Marketing Science, Vol. 27, No. 1, 15-25
- Deniel Kahnman and Amos Tversky (1983), “Choices, Values, and Frames”, American Psychologist, Vol. 39, No. 4 341-350