As a keen student of finance, you’ve decided to spend $10 for a ticket to the latest superhero movie. But between the popcorn stand and the door to the theatre, you somehow lose your ticket. The cinema has no record of your purchase, and you’re told that you’ll need to buy another ticket to get your Superman fix.
Would you buy another ticket – in effect doubling the cost of seeing the movie – or just go home and watch television? In a landmark 1984 study by behavioural finance psychologists Daniel Kahneman and Amos Tversky, only 46 percent of the 200 respondents would have purchased another ticket.
But when this scenario was compared to losing a $10 bill on the way to the theatre – before buying the movie ticket – a massive 88 percent said they would get another $10 to buy the ticket to see Batman.
Both cases involved a total of $20. But nearly twice as many respondents were happy to spend another $10 after losing that much in cash, versus losing a movie ticket that was worth as much.
The study concluded that this apparent contradiction was because in our minds, we placed only $10 into our mental “movie ticket account.” Losing the first ticket meant that buying another $10 ticket would result in $20 being debited from this mental account.
On the other hand, the $10 lost on the way to the cinema was not considered part of this account. So we don’t feel as bad purchasing a ticket as only $10 will remain debited from the movie ticket account.
We tend to put our money into separate categories in our brains, and give these categories different values based on the source of the funds, and what we intend to do with it. This is called mental accounting bias and it leads to us make irrational spending decisions.
People who win millions in the lottery sometimes end up bankrupt. Gamblers who briefly win big often leave the casino with no money. Similarly, a lot of tax refunds are viewed as unexpected windfalls and are spent quickly rather than saved – even though we’d never spend so recklessly if that had been part of our regular paycheque.
This happens because we tend to spend more after mentally accounting for this money as “unexpected profits.” We treat the same amount of money differently, depending on where it came from.
Ultimately, the source of the money should not play a role in how much of it we spend. But in reality, this is usually what happens.
Mental accounting bias often creeps into our investment decisions, too. It explains why we have no problem storing large sums of money in a 5 percent interest savings account… while carrying a hefty balance on a credit card that charges 20 percent interest.
Psychologically we feel secure knowing our savings are earning interest, even though using these savings to pay off the credit card balance would save us 15 percent.
If you buy a stock at $50 and it goes up to $100, before falling to $60, have you gained $10 or lost $40? Often as a result of mental accounting bias, the fact that you initially made money means that you probably won’t take the normal steps to protect your profit when the stock is at $100… steps that you would have taken at $50.
The bias also means that we label some of our money – like the portion of our savings we set aside for retirement – as completely “hands off.” We won’t invest any of it even though there is every chance we could make more by investing in, say, the stock market. This can hamper our investment returns big time.
How can we fix this problem? Always keep in mind that money is money – it is all the same. It doesn’t matter whether it comes from your salary, a bonus, a tax refund or a win on the horses. Remain rational and objective. Don’t let labels sway you from this.
And remember that spending an extra couple of grand on a $50,000 car is the same as spending $2,000 more on a bottle of champagne. As soon as you drive the car home, or open the bottle of champagne, the $2,000 is gone.
And when you invest, remain disciplined, no matter whether you are have made $10,000 in a day or you are down by the same amount. Come prepared with an investment strategy to achieve your financial goals, and perhaps even a plan for how much you will invest in stocks, bonds and cash.
By treating all money with the same value, you will go a long way towards avoiding the mental accounting bias.