Your Accountant Has Two Pockets (Its You!)

If you were your own accountant, would you fire yourself?

This question is actually not entirely hypothetical. You’re an accountant. You account for your money either passively, actively, apathetically or a combination of all three. Money comes in and money goes out.

So how good are you at your job? If your accounting strategy is to “keep track in your head” – the strategy used by most – I can all but guarantee one thing: You’re not very good. Not because you’re stupid but because you’re human.

Consider this example:

Just before you left the house, you put two things in your pocket – a $10 bill in your left pocket and a movie ticket (worth $10) you purchased in advance in your right pocket. You arrive at the theater and as you reach into your right pocket to pull out the ticket, you discover that it’s missing. You’ve lost the ticket. Would you fork over another $10 to see the movie?

Only 46% of the participants said they would spend another $10 for a ticket. When asked why, they generally pointed out that the cost of the movie – now $20 – was too much.

Now consider a second scenario: Just before you left the house, you put a $10 bill in your left pocket and a $10 bill in your right pocket. You arrive at the theater and as you reach into your right pocket to pull out $10, you discover that it’s missing. You’ve lost $10. Would you fork over the other $10 to see the movie?

In this scenario, an astonishing 88% of the participants said they would! Why? Because the movie ticket was still only $10. The other $10, which was lost, has nothing to do with a movie ticket!

If you’re keeping score at home, the two examples are identical. Thus, they should result in the exact same answer. If you would buy a ticket in one example you should buy a ticket in the other. But it’s clear that’s not what we do. So why are we so susceptible to this oddly inconsistent behavior?

Mental Accounting

Mental accounting is the reason we’re not very good accountants. It refers to the tendency for people to separate their money into separate accounts based on a variety of subjective criteria, like the source and intent of the money.

Mental Accounting helps us think faster. As money transactions happen we can easily and even subconsciously store them in a matter of seconds. But this comes at a price: Mental Accounting distorts reality which then distorts our decisions.

Is a Dollar a Dollar?

dollar cubeMoney is supposed to be fungible, which is a fancy word for interchangeable. Money that you receive in the form of salary should be treated the exact same as money received in the form of a rebate or gift.

But time and time again our behaviors with money prove that a dollar is not always a dollar. Some dollars mean more than others. And this lack of fungibility causes us to do some really silly things within an environment in which fungibility is one of its primary principles.

Still not following me? Let’s go over some examples that I’m sure we’ve all encountered at least once in our lives.

Examples of Mental Accounting

When Is It Okay to Save $20?

Assume you are about to buy a car for $20,020 but realize that the next city over is selling the exact same car for $20,000. Would you leave and go the other city to save $20? Probably not.

Now assume you are about to pay $120 for a pair of dress shoes. But the store in the next city over is selling them for $100. Would drive to the other city to save $20? Probably so.

Why is a drive to another city worth $20 chosen in one instance but not in another? Reality isn’t reality. Reality is relative.

Savings Account with Debt?

Assume you had $30,000 in savings with $20,000 in student loans. What would you do?

It’s becoming more and more common, mostly due to outrageous student loans, for “affluent” families to have a good chunk of savings at their local bank with very low interest rates while still having large amounts of debt with high interest rates.

Why would people have debt and savings? They look at them as if they are two separate funds. One is savings and the other is an expense (or better yet an “investment”). This is not only illogical but detrimental.

$10,000 in savings and $0 in debt doesn’t sound as good as $30,000 in savings and $20,000 in debt. Mental Accounting hides the fact that not only is it the best mathematical option, it’s also the one with the least amount of risk. In this situation, $10,000 in savings isn’t better than $30,000…it’s a lot better!

Tax Refunds Are Not Stimulus Checks

accountantOne of the most bizarre examples of Mental Accounting is tax refunds. There are entire advertising campaigns around April and May trying to give people good ideas on how to spend their tax refunds. If money was fungible these advertisements wouldn’t even exist.

People look at this once-a-year payment (for those who are entitled to a refund) as “found money.” There is interesting research that shows found money, such as unexpected cash from lotteries, cause people to spend well over the amount of money they found. Why? Because of Mental Accounting!

Remember stimulus checks in 2008? For a family of four the check was $1,800. As it turns out, a $1,800 check from the government is treated much differently than a $1,800 check in the form of compensation for work rendered. Because they viewed this check as “found money”, how much do you think they spent? 50%? All of it? Nope.

By giving someone a $1,800 check, people spent an additional $4,500! Suddenly it becomes impossible to say no to things because you’re not spending your money, you’re spending found money. A little bit of this and a little bit of that adds up quicker than we can mentally count.

(Even more stunning: An $18,000 check would have resulted in roughly the same amount of money spent – $4,500. Small amounts of found money are deemed spendable, whereas large amounts of found money are deemed savable.]

What makes tax refunds so bizarre is that not only do people treat them as found money (whammy) they aren’t even found money (double whammy)! A tax refund is simply a delayed payment for working. It’s your salary…not paid on time. If we thought about it like this I doubt people would spend time searching how they can spend their tax refund.

So the next time you get a tax refund treat it like it’s from your salary…because it is!

Which is better: Salary Increase or Salary Decrease?

Imagine you are deciding between two jobs. The deciding factor will be salary. Which job would you take?

Job A: $60,000 in year 1, $50,000 in year 2 and $40,000 in year 3.

Job B: $35,000 in year 1, $45,000 in year 2 and $55,000 in year 3.

Most people would choose Job B where salary has increased each year for three years.

But why? Job A makes significantly more money in three years – $150,000. Job B only makes $135,000. You would have lost out on $15,000 because a salary increase has to be better than a salary decrease, right?

Maybe somethings aren’t what they seem.

Why Is Gas Price the Only Factor to Influence Gas Consumption?

Some parts of the country are impacted more than others but regardless of where you live, you have undoubtedly experienced rising gas prices at some point. As expected, gas consumption is inversely related to price. As price goes up people drive less.

gasWhat’s interesting is the fact that gas consumption is only impacted by gas prices. Why? Because the expense for gas is stored in our mental ledgers as Gas Expense. In reality it’s money; the same money that is used to buy groceries or take vacations with.

An equivalent decrease in, say, salary (either a direct reduction or an indirect reduction, such as paying for education) should impact gas consumption just as much as an equivalent increase in gas prices. You are willing to save money on gas consumption when gas prices increase, but not when your salary decreases by an equivalent amount. This is quite illogical or at the very least inconsistent.

Associating gas prices with gas consumption is much easier than trying to associate it with completely unrelated outflows. Just because it’s easier on our brains doesn’t make it logical.

My philosophy: Don’t worry about gas prices.

Expensive Wi-Fi at Expensive Hotels

Have you ever wondered why Super 8 Motel offers free Wi-Fi but the Ritz Carlton doesn’t? People won’t pay for Wi-Fi at budget motels like Super 8 but they will at the luxurious hotels like the Ritz Carlton.

Why? A $30 per night charge seems like a lot when you’re only paying $80 for a room. On the other hand, a $30 charge seems minuscule when you are paying $1,000 for the room or suite.

According to the Wall Street Journal, add-on charges for in-room Internet service let hotels advertise a lower price and then boost per-night revenue by 5% to 10%. These hotels are doing a phenomenal job at exploiting Mental Accounting.

Are You Hungry?

It would be easy to think that the amount of food we eat would be directly related to how hungry we are. Well, we would also be wrong.

bowl mmIn one experiment a bowl of M&M’s was left in an apartment foyer for residents to eat. It was a two day experiment using the same bowl for each day. The only difference was that on the first day there was a tiny scoop for the residents to use and on the second day there was a much larger scoop.

People on the second day ate 66% more M&M’s. Don’t people eat until they are satisfied? And why wouldn’t it be the same amount each day? The people on the first day could have just used more scoops. Did the bigger scoop somehow make people more gluttonous?

Obviously the scoop didn’t transform people from fitness enthusiast to fat slobs. What it did do, however, is change their reality.

What is more closely associated with health: Calories or Scoops? But people don’t count calories, they count scoops!

In Mutual Funds and Clip Coupons

If you could design an experimental factor that would maximize irrational behavior it would be coupons.

clip couponCoupons bring many examples of Mental Accounting, one of which is when people invest in actively managed Mutual Funds but clip coupons to save money on soup and deodorant.

There is a lot of debate between passively managed Index Funds and actively managed Mutual Funds. What is not debatable is the difference in fees between the two. Mutual Funds carry significantly more fees (many of which are hidden).

Now, the fees may be worth it if your funds are outperforming the market (actually outperforming in dollars, not percentages associated with Average Rate of Return). But considering very few do outperform the market, you may be losing tens of thousands of dollars over your investing career. No amount of coupons will make up for that – but it sure does feel like it does while standing in the checkout line!

People don’t count the amount of money they save. They count the amount of times they have saved money.

Trip to Hawaii!

Scenario 1: Assuming you want to go to Hawaii, a $2000 Hawaiian vacation package is on sale for $1600.

Would buy it? Most people say yes. Why? Because it’s a good deal!

Scenario 2: A $2000 Hawaiian vacation package is on sale for $700. You think it over for a week but by the time you try to purchase the travel package the sale is no longer available and the price has jumped to $1500.

Would you buy it? Most people say no. Why? It’s not a great deal! You missed the great one!

Clearly, the not-so-good-of-a-deal ($1,500 ) is cheaper than the amazingly-great-deal-of-a-lifetime ($1,600). But you’re mind doesn’t perceive it that way! People don’t compare prices. They compare deals.

Maybe We Can Become Better Accountants

I hope these examples illustrate how difficult it is to properly manage money – not because we are stupid but because we are human. There are certain things that we do really well but there are also things that we do terribly – managing money is one of them.

The problem with money is that we are asking ourselves to do things that go against our very nature. At no point in our evolution was it necessary or advantageous to look much beyond the present moment. Even more, we would never take the time to take abstract comparisons and make them more concrete. What a waste of time…until it wasn’t.

My proposed solution: Create and follow a budget. It’s not sexy with theatrical fireworks bursting the minute someone mentions its existence but it’s surprisingly effective. We’re all accountants. We’re also all idiots. Why don’t we make ourselves better with less effort?

Don’t try to correct evolution. Just try to correct the environment in which evolution has been forced to live in.

Question: Have any other examples of Mental Accounting? Does Mental Accounting contribute to our illogical decisions regarding purchases? Is it possible that Mental Accounting is occasionally good?

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10 Comments

  1. This is a thought-provoking concept. I agree that it’s just not humanly possible to be completely consistent about how we think about and handle money. For example, I recently traveled internationally. After spending such a huge sum to get there, I wasn’t too mad when I got overcharged four dollars for something I bought there (even though I was really trying not to get ripped off!). If that same thing happened here, I’d go back for a refund. But then I tried really hard to avoid checked luggage fees for our in-country flights (the weight limit was much lower). I just didn’t want to pay for something kind of abstract, and that I thought I could avoid.
    Kalie @ Pretend to Be Poor recently posted…Thoughts from IndiaMy Profile

  2. “Create and follow a budget. It’s not sexy . . . ” You’ll have to talk with Jay at his site, Budgets are Sexy about that one : )
    Just yesterday, I received an unexpected $60 from the government. And what did we do? We got take-out for $57! We just felt smug about not having gone above the cheque amount. Why didn’t we put it towards the emergency fund we’re saving? Or the renovations we’re planning? Because it was “found money.” Now we know.
    Lots of great examples here. All too true!
    Prudence Debtfree recently posted…Obstacle to Frugality: “Rabid” StereotypeMy Profile

  3. Drew H

    Probably my favorite post yet Luke. Well done.

    As an accountant that does personal taxes, I deal with the tax refund example every year. No matter how I explain it to people some just don’t get it. You’re lending your money to the government interest free for a year and then acting like its Christmas morning when they pay you back.

    Another example of mental accounting that always gets me is when stores have sales. People leaving with arms full of stuff bragging about how much they saved…. So wait, you’re leaving the store with less money than you showed up with and you ‘saved’ money? Yeah I got $100 worth of stuff for $20. Saved $80. No you spent $20. (Still working on this concept with my wife haha)

    • “Attention customers: If you want to rip us off you should buy all of these great deals. Half price! Deal of the week! You get another one FREE!”

      *chuckles*

      *Rips off customers who think they are ripping off the company*

      Ahh

  4. Money is emotional thereby rendering it completely illogical at times. I am so guilty of mental accounting where I can separate student loans vs. retirement entirely. Like the two aren’t supposed to be added together in calculating net worth. Ha! It’s a denial technique 🙂
    Mrs. Crackin’ the Whip recently posted…My Expensive Makeup RoutineMy Profile

  5. Luke,

    We humans think that we are logical, yet the results tend to say something different when it comes to our decision making. I too touched on this in a post discussing emotional biases. You provided some excellent examples of these faulty decisions in your article.

    It seems that it deep down these Mental Accounting gyrations we go through are influenced by fear and greed. We all attempt to get the best deal, not lose money, feel good about our decision, and take the choice that seems to be better, often without doing the math to determine the best solution. Marketers have figured that out and target their advertisements to our weaknesses.

    The fun challenge is to figure out what methods they are using when we are in hypnotized by their message. 🙂

    Take care,
    Bryan
    Bryan@Just One More Year recently posted…4 Significant Lifestyle Changes in the Past 40 YearsMy Profile

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