Behavior

Is That Real Money Or Fun Money? The Familiar Trap Of Mental Accounting

When is $10 not worth $10? That might seem like a ridiculous question, but in fact, $10 can have vastly different values in your head depending on where it comes from and what you've decided it's meant for. For example, you'd probably happily pay $10 for a cocktail if you were on vacation, but tack $10 onto your cell phone bill, and you'd likely complain to customer service. This kind of financial psychology is called mental accounting, and while it's incredibly common, it can get you into trouble.

Related: Loss Aversion Says That The Pain Of Loss Is Stronger Than The Joy Of Gain

One Of These Bills Is Not Like The Other

Economist Richard Thaler was the first to introduce the idea of mental accounting. He shed light on this irrational tendency with a thought experiment originally posed by Daniel Kahneman and Amos Tversky, which goes like this: Imagine that you've just paid $10 for a ticket to a play. As you enter the theater, you realize that you've lost the ticket. Would you pay $10 for another ticket? Ok, imagine now that you're at the same theater, but as you walk up to buy a ticket, you realize you've lost a $10 bill. Would you still pay $10 for a ticket?

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In both cases, you're losing $10—but somehow, one feels very different than the other. When Kahneman and Tversky asked this question, they found that less than half of the respondents would buy a second movie ticket if they had lost the first, but a whopping 88 percent would go ahead and buy a ticket if they had lost $10. That's because in the first example, the $10 was already assigned to the mental account for attending the theater—buying a second ticket makes the play "cost" $20. But the cash you lost wasn't assigned to anything, so it's easy to write off.

Same goes for large and small purchases: people also said they were more likely to drive across town to save $5 on a $15 calculator than they are to save $5 on a $125 leather jacket. As Wired explains, "Their driving decision depended less on the absolute amount of money involved ($5) than on the particular mental account in which the decision was placed. If the savings activated a mental account with a miniscule amount of money—like buying a cheap calculator—then they were compelled to drive across town. But that same $5 seems irrelevant when part of a much larger purchase. "

Money Is Money Is Money

The reason mental accounting is so irrational comes down to the concept of money's fungibility: that is, the fact that all money is the same, no matter whether you assign it a purpose or not. Quirks of psychology, however, lead us to behave as if that's not so. Loss aversion makes us treat money we already have as more valuable—or less fungible—than money we might receive, say with a tax refund or a lottery win. Same goes for "found" and "expected" money. You're more likely to spend an unexpected gain, like a $5,000 work bonus, than you are to spend money you know is coming, like a $5,000 paycheck. Mental accounting is also why buying things with a credit card is so much less painful than buying them with a debit card: it uncouples the purchase from the payment, and turns individual purchases into part of a large, ordinary amount due.

Related: How the 50/20/30 Rule Can Help You Budget

So how do you behave more rationally when it comes to money? Understand that all money is the same, regardless of its origins or intended use. That means that unexpected money is the same as money in a paycheck; a $5 savings on a $15 purchase is the same as a $5 savings on a $125 purchase; and $10 lost is $10 lost, regardless of whether you've already bought a theater ticket. If you wouldn't spend it in one situation, you might want to rethink spending it in this one.

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Written By Ashley Hamer May 2, 2017