Series 2, Episode 10: Mental Accounting
Welcome back to the bitesize behaviour podcast and today we’re looking at a really quite fascinating behavioural bias… mental accounting.
What is mental accounting? Put simply, mental accounting is where we tend to treat various sums of money differently based on mental categorisation. For example, the way that a certain amount of money has been obtained, can have a significant impact on what we end up doing with that money - whether we spend it, invest it or something else. In other words, we will treat money that we earn through hard work, differently to money that we may inherit, win, or even get through an annual bonus from work. You may not consciously think about it, but subconsciously we partition our money and place more or less value on it depending on which mental pot we have put our money in.
But what’s interesting of course, is we stop and think about this just for a minute, is money is money.
All money is the same, regardless of its origins, or its intended use. But because we’re prone to mental accounting, we can make snap decisions about what we’re going to do with money and how it should be allocated that can have a long term impact on our overall financial wellbeing.
BORROWING AND SPENDING
As an example, it’s no use having a regular savings account to save for something that you really want, like a new car, whilst at the same time paying off a credit card debt which may have a really high interest rate - or APR. The savings account will be earning little or no interest, whilst you will collecting credit card debt the longer its outstanding.
Actually - let’s try and bring this to life.
Here are three questions, and think about these as I go through each, and be honest with yourself. Each question is the same. What would you do with the money?
Question 1. You receive a cheque in the post from the Tax People because you overpaid tax last year by £250. What would you do with the money?
Question 2. Instead of receiving birthday gifts, everyone gave you £50. At the end of your birthday, you count up £1,000. What would you do with the money?
Question 3. You buy a scratch card on your way home from work, and realise that you’ve won £5,000. What would you do with the money?
Now, let me pick up on that last question - the scratch card winnings. My guess, and this won’t apply to everyone, is that many of you would spend it on something rather nice.
Something you really want but perhaps couldn’t afford, until now. That’s what the evidence suggests people will do. Because we see it as a windfall - money we didn’t have a few minutes ago - we treat this differently that if we had earned and saved the £5,000 through hard work.
But, what if instead of spending it on something now, you stop for a minute and think - what could that £5,000 do for me if I put that into my pension? I’m 45 now, by the time I’m 70, that £5,000 could be worth nearly £17,000.
Would your mind be changed if I said "you can have £5,000 now, or £17,000 extra when you retire". Would that change your mind?
Of course I’m getting into framing and present bias - behaviours we discussed in previous episodes of this series, but in these events, under these circumstances, the way we place mental accounts around our money has a real impact on what we end up doing.
But I also have to say this because I’m making it sound like it’s all bad - and we’re doomed... absolutely not.
Mental Accounting can be used as a force for good, especially when it gets us to save for our future, or when we can create a separate money pot for a particular goal and stick to it.
That’s a good use of mental accounting because it is helping us put into practice good financial behaviours. Earmarking money for a goal or for our future can prevent some people from spending that money on other, more immediate things.
In a previous episode we talked about present bias and the power of now versus the future? Well, saving for our first home, or simply ring-fencing money for a specific goal like a big holiday, are all reasons why we use, or need, mental accounts. The simple fact is, that treating all our money as one pot of money is not what we are really comfortable with. That’s not to say that’s right, by the way, but it does mean that we can use this behavioural tendency, some times, to our advantage.
With mental accounting be careful to not be too rash, or quick to spend the money you have simply based on how it ended up in your pocket. Think about your broader financial needs and think about how you can get money to work for you. If you need to, if it helps, create mental accounts - pots with specific goals, because this could create the right behaviours that lead to more financial stability.
That’s it for today. In the next episode of Bitesize Behaviours we’ll look at a behaviour that is influenced by our recurring thoughts. That's Attentional Bias.
See you next time on bitesize behaviour.