Behavioural Finance, Part 9: Mental Accounting

Welcome to Part 9 of our Behavioural Finance series. If you’ve missed the earlier parts of the series, you’ll find our Introduction to Behavioural Finance here, Part 2: Prospect theory and loss aversion here, Part 3: Availability and Representativeness here and Part 4: The Law of Small Numbers here and Part 5: Anchoring, Conservatism and Herding here and Part 6: Overconfidence and Under-Confidence here. and Part 7: Self-Serving Bias here and Part 8: Projection Bias & Magical Beliefs here.

Mental accounting is everywhere. We use it every day. It’s so omnipresent that we barely realise we’re doing it, but once you become aware of it, there’s no avoiding it. As an idea, it sprang from a question economist Richard Thaler asked himself one day in the late seventies: ‘How do people think about money?’ And in his own words, he’s been asking it ever since:

“I have continued to think, write and talk about mental accounting for the rest of my career. It is a lens that helps me understand the world. Thinking about mental accounting can be contagious. You may soon find yourself blurting, ‘Well that really is a mental accounting problem.’” 1

In short, mental accounting is our tendency to think about money as being marked for different purposes. As an example, someone might have a large credit card bill they need to pay off over a number of months. At the same time, they keep a piggy bank of spending money on the kitchen table to save for their summer holiday. The summer holiday spending money is not to be touched under any circumstances, even though delaying paying off their credit card will only cost more money in the long run. Rational economic theory says that it’s a no-brainer to use the money in the piggy bank to pay off the debt. However, once someone has marked the piggy bank money as too important to be touched, this emotional connection can make it very difficult to use the cash for any other purpose.

There can also be advantages to mental accounting. As we have seen, there can be downsides, but sometimes I believe it can actually help a certain type of investor to think of their money as occupying different ‘pots’. It encourages investors to ringfence a portion of their funds – for example, their children’s school or university fees – and conditions them not to touch it as it’s “not their money”. The same applies to retirement savings if it encourages people to set sufficient funds aside for the future.

Other cases of mental accounting can be spotted in how we treat money we have won or found. Studies have shown gamblers are much more liberal and less emotionally attached to money they have won in a casino than they might ordinarily be with their funds. There’s a sense that losing it doesn’t harm or hurt us as much because we haven’t budgeted for it and it’s come to us through good fortune.

Sunk Costs

We introduced this series on behavioural finance with an example of two basketball fans who decided not to use free tickets to a basketball game as the weather was too bad to make the journey, but who agree that had they bought the expensive tickets they would have attempted to drive through the blizzard. This is an example of how we’re unable to ignore ‘sunk costs’. Sunk costs are the name economists give to things or services we’ve paid for that we can’t get back. Another example is over-ordering at a restaurant but keeping on eating until you’re bloated and queasy because you’ve paid for the meal and you don’t want to ‘waste it’. Traditional economists would say that as we can’t get sunk costs back, we should just ignore them, even if we’ve chosen badly. (To be fair, behavioural economists would say this also, they would just acknowledge that doing so is far from easy).

Investing in property can be a good example of this. At First Wealth, I met with a couple who owned a holiday home. One wanted to sell it as they rarely used it, and the other wanted to keep it as they spent a significant sum renovating it and wanted to get their money’s worth. I explained that the amount that has been spent on the home is irrelevant if it’s not being used and, also, that any renovation work will be included in the value when sold. However, the reluctant seller remained reluctant. So, I changed my tack and asked if they would be more open to selling it if it was agreed that they would earmark all the proceeds solely for holidays and enjoying themselves in future. They said yes. Sometimes, as advisers, we need to be creative in finding a way forward!

Sunk costs don’t just apply to money, they can also apply to an investment of time. We’ve all seen a hopeful entrepreneur on Dragon’s Den who has been pitching their product for so long that they can’t seem to give up and accept it’s not going to be a success. They stick with it as they’ve already invested so much time in it. As investors, it’s important to remind ourselves that what’s happened in the past has gone and we need to make our decisions based on where we are today.

Professor Brett Kahr has underscored:

“In psychotherapeutic work, we often observe the notions of “sunk costs” and “mental accounting”, especially in relation to troubled marriages. For instance, couple psychotherapists frequently encounter partners on the brink of divorce who ask themselves, “Is this marriage still a good investment? After all, we have sunk a lot of time and money and emotion into this partnership. Should I remain?” In other words, will one’s large investment in another person still reap significant dividends? In such circumstances, couples often have difficulty deciding for themselves, in view of the profound mixture of love and hatred, of tenderness and disgust, and of loyalty and infidelity which scar so many intimate marriages over time; therefore, just as many of us will require a good financial adviser to help us with our “mental accounting”, so, too, might we need the services of a good psychological professional to assist us likewise.”

Questions to Ask Yourself

How strongly do you agree or disagree with the following statements?

• Having multiple investment accounts is a good way to distribute money among different goals.
• I would rather spend dividends on luxury purchases than reinvest them.
• I would be less likely to sell an investment that had lost money since I bought it.

The next post, number 10 in the series, is our conclusion! 

1 Misbehaving: The Making of Behavioural Economics, p55

This document is marketing material for a retail audience and does not constitute advice or recommendations. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.