With 2015 about to come to a close, I have a lot to reflect on. I did an exchange semester for university in Europe, started dating my lovely girlfriend, graduated university, travelled Southeast Asia for two months, started my first full time job, and created this blog.
I have also discovered how much I enjoy reading books this year. James Altucher, in “The Choose Yourself Guide to Wealth”, said that: “reading is the best return on investment. You have to live your entire life in order to know one life. But with reading you can know 1000s of people’s lives for almost no cost. What a great return!” And it’s true. Books are amazing!
Many of my blog posts are inspired from reading novels. This post is no exception. I am currently reading “When to Rob a Bank” from Levitt and Dubner, which is a collection of blog posts from the popular Freakonomics blog. Note, “When to Rob a Bank” is an interesting hard-copy book to read in public. Some people stare at you with a frightened look on their face. Others stare with a conniving smirk as if they want to get in on your upcoming heist. Yes, one of the posts in the book is titled “When to Rob a Bank” (which I have not read yet actually – it must be at the end of the book). But this post was inspired by this blog post from the book.
Now for an awkward transition into my post…
Imagine you just arrived at a movie theater to see a movie. As you reach into your coat pocket to pull out the $10 ticket you purchased online, you discover that you lost it. And you don’t have your receipt. Would you pay another $10 to buy another ticket to see the movie?
Compare this to a second scenario where you did not buy your ticket online, but when you arrive at the theater, you realize that a $10 bill fell out of your pocket along the way. It’s lost. Gone forever. Would you still buy the movie ticket?
This question was asked to respondents in an experiment. Turns out, only 46% of those who lost their ticket were willing to buy another one, whereas 88% of those who lost $10 in cash were willing to buy another ticket. But $10 is $10. So why do our answers change? Because of mental accounting.
The idea is that we create individual spending accounts for things like entertainment, groceries, eating out, and travel in our minds. If we feel like we have overspent in a single category, we will constrain purchases in that category, despite continuing to spend money in our other categories. In the above example, going to the movie might fall in your entertainment account. Having to buy a second ticket makes the movie seem too expensive, since you now have to spend $20 to see the movie instead of the $10 that you originally anticipated. The lost cash, on the other hand, is not charged to the mental account of the movie, which is why most people do not mind paying another $10.
Consider this situation…
Would you drive 20 minutes out of your way to save $5 on a $15 calculator?
Would you drive 20 minutes out of your way to save $5 on a $125 leather jacket?
68% of people studied said they would drive to get the calculator but only 29% for the jacket. In both cases, you are saving the EXACT SAME AMOUNT. But $5 off $15 sounds a lot more appealing than $5 off $125.
Another aspect of mental accounting is that people treat money differently depending on where it came from. What do people often do with their bonus money, lottery winnings, tax refunds, inheritances, money found on the street, or cash gifts? They spend it. Why? These sudden gains are often seen as “free money”. People spend a lot more of this “free money” than they do with “normal” salary money.
Let’s look at a few more examples of mental accounting…
Add-ons to Expensive Purchases
Let’s say you want to buy a new car. The base model costs $25,000, but you walk out of there spending $30,000. Wait, what? The car salesman convinced you to upgrade to get a heating steering wheel, a larger sunroof, paddle shifters, and an electronic parking break. And they even threw winter tires into the package for “free”. What’s an additional $5000 if you are already spending $25,000, right? The same idea applies to extended warranties on electronics. $100 Apple Care purchased by itself seems expensive. But adding $100 when purchasing the $800 iPhone makes it a lot more justifiable.
Credit Card Spending
I recently read Dave Ramsey’s “Total Money Makeover”. Dave encourages people not use credit cards at all. Why? In addition to not paying off their credit cards every month, most people also spend more with credit cards than they do with cash. I get the purchase now using a credit card, but I don’t have to pay now. Yes, you get to pay at a later time, but you still have to pay! And that dollar you spend on your credit card will cost you more than a dollar if you don’t pay on time.
Picture this scenario… You are at a Las Vegas casino with your friends. You sit down at a blackjack table with $100 and end turning that into $500! Right before cashing out, you go to the roulette table and bet your $400 of winnings on black. It lands on red. You lose your $400. But you didn’t technically lose your money, right? You are still leaving with the $100 you came in with. This is known as the house money effect – people start to make riskier bets after they start winning. “It is the house’s money, not my money.” The same idea applies to investing. After a bit of success you might find yourself making riskier investments.
Low interest investment, high interest debt
I have read stories about people who have thousands in credit card debt, and also have thousands sitting in a low-interest investment like a GIC. These people likely have a different mental account for their savings and for their debt payments. But it is illogical to have savings in an investment vehicle earning a couple percent at best while carrying around credit card debt with 20% interest. Unless you can find an investment that guarantees a return higher than the credit card interest rate (and if there is one I want to know about it), the credit card debt should definitely be paid off first.
So despite what our minds might think, a dollar is a dollar regardless of where it came from or what we are spending it on.
Do you have any other examples of mental accounting?