07.23 Mental Accounting: Our Motivations Behind Spending and Saving

We are all more human than otherwise. We don’t behave rationally with money. Our brain plays tricks on us. We have emotions.

You find a $10 bill on the street. How do you feel? Found money? Free money! The brain clicks into immediate gratification mode. This is our animal side. We are wired for the adrenaline rush of now, so let’s spend it! Yet the Chicago School of Economics for decades had everyone believing that we are rational actors. They actually thought people would deposit the found money in our checking accounts and apply it the same way as $10 earned from work.

And on what planet was this?

Real people practice mental accounting, first named by University of Chicago business school professor Richard Thaler. Thaler and colleagues proved that we often apply subjective, not objective, criteria to money. We separate it into irrational accounts.

We may have credit debt at 15% interest per year, yet at the same time have a vacation or entertainment or other fun fund. Think of it as putting all your change in a jar, taking it to the bank each year and treating yourself to a dinner out, while you carry a high interest credit card balance month to month. It’s rational to pay down the debt; you get an immediate gain whatever the interest rate. If it’s 15%, that’s 15 cents on the dollar for every year you’d have that debt. You can’t make that kind of money pretty much anywhere. But that reward is distant, while the money for the vacation is here now. Yes, it may feel good for now, while the debt becomes more and more onerous.

Behavioral finance research also found that we make larger bets if we have to use credit cards rather than cash. Credit is somehow less real, yet $100 on a card is no different than a $100 bill in your hand. A credit card charge runs the risk of high interest added, but it’s somehow remote, distant. We’ll deal with it another time.

Lots of investors practice mental accounting. They divide their investment cash into lower risk stocks and then take a smaller amount for “a flyer” on something sexy, speculative—fun! Fun? Really? Would they take the same money and go to the casino? That’s what they’re doing. Over time, this will reduce investment gains.

Life would be a colossal bore if we only made entirely rational financial decisions. After all, we earn psychic income—non-monetary benefits—from spending our money on dates, birthday gifts or charitable donations, for example. So life is a balance, living in the present while saving and investing for the future.

The Red Queen tells Alice Through the Looking Glass that “The rule is, jam tomorrow and jam yesterday – but never jam today.” Not so. We can have jam today, but saving jam can mean more tomorrow.

Tom Jacobs is Investment Advisor and Portfolio Manager with Dallas’s Echelon Investment Management. You can reach Tom for a consultation at tjacobs@echelonim.com.

Photo: Ryan McGuire