My piggy bank is a control freak
What is it?
You planned to go to a concert this weekend. The ticket costs 100 € and you want to buy it at the box office right before the concert. For that you put a fresh 100 € bill into your wallet. As you arrive at the event location, you realize that you lost the money on your way there. “F*(#”! you think to yourself. However, you could still enjoy the concert as they also accept credit cards. What would you do?
Now imagine a slightly different version of this scenario where bought a ticket beforehand with an early bird discount (what saved you 10 € from the regular price of 100 €). Now, when you arrive at the event location, you realize that you lost your ticket on your way there. “$h!+”! you think to yourself. You could now either buy a second ticket at the box office to the original price of 100 € or decide to go to a nearby pub to flush down your frustration. What would you do now? Concert or pub?
If you are like most of us, then you would buy the ticket with your credit card in the first scenario but go to the pub in the second one. Kahneman and Tversky did a very similar study where the numbers for buying a (second) ticket at the box office were 88% for scenario1 and only 46% for scenario 2.
The question for me is: why is that? And the answer is: because of mental accounting!
According to research, people treat money differently depending on where it comes from and what it is used for, rather than viewing it as an abstract means of payment which sums up in one “bottom line end result”. Some people even keep a special money jar or piggy bank set aside for their next vacation, a new play station or just for “bad times”. And the money that they allocated to one of these funds is strictly kept for its purpose, even if they would have to go into the red on their bank account for an unexpected bill and have to pay short-term interest for that.
Mental accounting can also explain our preference for free shipping of goods which we order over the internet. We assign an account to the thing itself and one to the act of shipping. And as some vendors started to deliver at no additional cost, we are no longer willing to accept other vendors to charge us for this. In other words, we are not willing to pay any money from our shipping account (although we know that noting comes for free and that the cost for the transportation will be added to the product price somehow). The purely rational approach would be to take the sum of both product + shipping and pick the cheapest one. But we usually tend to compare the prices separately (according to our mental accounts): product alone, and shipping alone.
But why is mental accounting a problem? Generations of families used this method successfully to make ends meet when money was tight. I think the free shipping example illustrates where the issue is. If our mental accounts build up (arbitrary and irrational) boundaries in our brains just for the illusion of control and simplicity, we can make wrong decisions leading to negative effects on the “bottom line end result”. I’m sure every cost/profit center owner who was to work with corporate controlling knows exactly what I’m talking about…
Why does it happen?
I believe the reason why we practice mental accounting is just to simplify the world around us. The usually small number of imaginary money jars we define for ourselves gives us the feeling of structure and control. It is much easier for us to handle each of these buckets separately and by doing so keeping an overview of our financial status than having to mentally track and remember all the zillions of items on an average bank statement.
Mental accounting is not bad per se. Sometimes it can make you even happier. A while ago I read a nice example from an economics professor who hated the feeling of anger and frustration when he got a speeding ticket. Here’s what he did: At the beginning of each year, he set money aside for charity donations. As this money was “already spent” he used this mental account to pay the hated speeding tickets; and with this simple life-hack he got rid of the pain of paying for the tickets.
How can we avoid it?
Knowing the effect is the first step to keep it under control. I also would recommend reviewing the accounts that we created every now and then. The biggest problem to me in this regard has always been switching from one “accounting system” to another one. And fighting the irrational feeling of using money “from a wrong bucket”. Where half of the work is done when I realize the irrationality of these feelings.
What’s your thinking around that?
Does this sound familiar to you? Any own experiences or stories you would like to share? Please start a conversation in the comments section!
#decisionmaking #bias