Mental Accounting Creates Inconsistent Behavior
Many of the investing and behavioral biases we’ve been discussing are most readily understood when contrasted against classical economic thinking. Such is the case with “mental accounting”. Classical economic theory holds that money is fungible, that is, every dollar is identical to every other dollar. However, observed behavior in real life shows that many people don’t act as if this were true. Richard Thaler, a Nobel prize winner in Economics coined the term “mental accounting” to describe such behavior and its associated impact on our financial decision-making.
Thaler noted that many people classify some dollars differently than others and keep separate mental ledgers for the various categories. Sometimes, the source of the money dictates its classification. Dollars received from work/wages are treated differently than dollars received from a windfall or gift. Some people will treat the windfall as “found money” and spend it more readily or invest it more aggressively. We should treat each dollar identically but clearly do not.
Gamblers have long demonstrated this behavior by betting their winnings more aggressively on the belief that “they are playing with the house’s money.” Marketers have exploited such thinking every spring by launching promotional campaigns when many people receive income tax refunds. Even though the refund dollars were originally earned by the work of the taxpayer, they are somehow viewed as a windfall when our own money is given back to us by the U.S. Treasury.
Mental accounting can result in other irrational behaviors. Many people keep substantial balances in low yielding savings vehicles while simultaneously carrying large unpaid balances in expensive credit card accounts. While it’s true that maintaining an emergency fund is an important financial fundamental, paying down high cost debt will often be a better use for those funds. Conversely, many investors approaching retirement are tempted to make large withdrawals (and generate an associated income tax bill) from an IRA earning 7-10% annually in order to pay off a mortgage costing under 3%. Investors also display these behaviors by isolating more speculative investments from their “safe money”. The net impact on their overall wealth is unchanged but somehow, it’s erroneously believed that keeping separate accounts will prevent spillover effects if the more aggressive investments head south.
If you would like to learn more about these and other wise financial planning moves, please contact us through our Level 5 Financial LLC website or via phone at 719-323-1240. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.