The Pros and Cons of Using Mental Accounting

Commercials are the worst. I avoid live television except for things like watching Xavier in the Elite Eight, but even then, I still avoid the commercials. I will literally pause the TV when it goes to a commercial break and sit there until I think enough time has passed that I can fast forward through them. 

The other day, though, I must have been off my game. I was watching some show and without realizing it, I got pulled into the commercials. One came on for the new, the amazing, the super-powerful Dyson V8 Absolute hand vacuum. I wish I could tell you I was intrigued by something less lame, but what can I say, I like a clean house. Anyway, the next thing I know, I’ve convinced myself I need one and am on my phone looking it up with the intention of buying it (This is why I avoid commercials.).

As I typed it into Google, I was already wondering how fast I could get it shipped when all of a sudden I saw the price. Ouch. Really? For a handheld vacuum? As fast as I had decided I needed it, I decided that price was crazy and I was not going to buy it. Disappointed, I almost closed the search window when another thought came to mind, “You know that’s about the same amount of money as we have in credit card rewards…”

What five seconds ago had seemed a decidedly outrageous price to pay for a vacuum, suddenly seemed more palatable. Why? 

Mental Accounting

Because of this thing known as mental accounting. Mental accounting is a term that describes our tendency to categorize or group money into different pots in our head and then make decisions about how to use the money based on that. It’s our mental way of saying, “This money is for this and that money is for that.”

Sometimes mental accounting is helpful. Perhaps you have an account dedicated to an emergency fund that you won’t touch for anything else. Or maybe you mentally earmark a portion of your bank account for your children’s college tuition. No harm there.

It can even be good at times to separate money into different buckets for short-term, mid-term and long-term goals so you can invest them in a way that is appropriate for the time horizon: more conservative investments for the short term and more growth-oriented investments for the long term. 

While it can work to our benefit, mental accounting can also work against us. When we create these buckets of money in our head, we can use those buckets to justify choices that aren’t ideal. In my case, I was treating my credit card rewards like "other money" that I was willing to part with more easily than I was the money I earn. I can rationally tell myself that $1.00 of credit card reward is worth no more or no less than $1.00 of earned income, but to me, it just feels different. The credit card rewards feel like found money. (For related reading, see: How to Effectively Compare Credit Card Rewards.)

This willingness to part with found money was documented in a study by University of Chicago professor Richard Thaler, the man who happened to coin the term mental accounting. He offered one group of people $30 outright and then asked if they would gamble it for a chance to win or lose $9, winding up with either $39 or $21. Out of all of the participants, 70% took him up on the offer. A second group wasn’t given the money upfront. They were simply asked if they’d rather take $30 outright or flip a coin and get either $39 or $21. Nearly two-thirds of those people took the $30 outright. The first group saw the $30 they received was a windfall and it made them twice as likely to gamble as the second group. I’m sure you’ve seen this at work first-hand if you’ve ever gambled your casino winnings with a lot more ease than the money you brought in your wallet. 

How We Spend Money

Although we rarely recognize mental accounting since it happens subconsciously, it happens all the time. People spend cash differently than they spend with credit cards. We’re willing to spend the interest and dividends from our portfolio but we don’t want to touch the principal. We keep money or assets we inherited because we still see it as Mom’s money. There are all kinds of reasons we treat certain money as different from the rest. (For related reading, see: The Spending Habits of Americans.)

If the consequence of this thinking is buying an over-priced vacuum, then it’s probably not a big deal (although I did manage to restrain myself once I realized what I was doing). What we must watch out for is being overly tied to our mental buckets. There are times when saving or spending from a particular bucket makes better financial sense. If we don’t recognize the way we’re thinking or if we become too tied to our mental accounts, it can lead to costlier choices that leave us worse off overall. Rather than piece by piece, the best financial decisions are made holistically and focus on things like reducing overall cost and increasing total return.

Our financial life has parts just like any other machine. Whether it’s a car, the human body or even a vacuum cleaner, it’s both the parts and the way those parts work together that will determine how long they last. If it’s our money that we want to last, we just might have to learn to kick the buckets. 

(For more from this author, see: The Best Way to Handle Financial Mistakes.)