Just like companies have different budgets for different departments, our human minds also separate our funds into different ‘accounts’ for lots of different things – car money, dinner money, rent money etc.
Yet, $100 is $100. The value of that $100 doesn’t change, regardless of how you feel about it or the emotional value you attribute to it.
Imagine you’re walking down the street and you find a $50 note on the ground. You’re excited – $50! You’re also saving up for a new car. You know this money would help towards getting your new car, but instead you take your $50 and spend it on a dinner out with your friends. You justify your actions by telling yourself that this money isn’t ‘car money’ anyway, so it’s ok to treat yourself to something special. Sound familiar?!
Mental accounting is a helpful way for our minds to process large amount of data. However, our minds let us down because they assign value to money subjectively, despite money having a consistent, objective value.
This means that despite $1 being equal to $1, our minds might assign a different value to that $1, depending on how we earned it, how we intend to use it, and how it makes us feel.
This occurs because our minds dismiss one of the key benefits of money: the value of money is consistent with other units of the same currency. In other words, your $5 is exactly the same as mine. But we each view that $5 differently, depending on the value we’ve allocated to it in our mind.
It’s a bit like putting our money in different bank accounts that we apply different rules to. Windfall gains from investments, bonuses, tax refunds, or finding money on the street, are especially powerful. We’re much more likely to spend windfall gains than money earned from our regular income.
We’re also much more likely to spend windfall money on luxury goods. Even though the money is exactly the same, the fact we acquired it in a special way makes us think we can spend it in a special way too.
If this sounds like you, don’t worry – you’re not alone! Even seasoned investors can be susceptible to this bias, such as when they view windfall gains differently and allocate that money to higher risk investments. By doing this, they are making decisions on each mental account separately, rather than viewing the portfolio return as a whole.
On the other hand, sunk costs – money that has already been spent and cannot be recovered – continue to affect our decision making because it’s still stuck in one of our mental accounts.
Say you’ve spent $150 to go and see a rugby match at the stadium. On the day the weather is awful, it’s raining, windy, cold and you woke up in the morning feeling a bit sick. To be honest, you’d prefer to stay home and watch the game on TV. But you feel compelled to go to the game, because to not do so would be a waste of $150.
Even though the money is spent, and the sunk cost should not influence your future decisions, you decide to go to the game because you opened a mental account in your mind after you bought the ticket and to not go would mean you’d have to close the account at a loss – and that can be too painful to bear.
This is obviously not logical behaviour! Your money has been spent and cannot be refunded. The only thing that should influence your decision are the costs and benefits incurred today.
Your money doesn’t come with any labels attached to it. The $5 you plan to use for the bus could also be used to buy a cookie, or something else entirely. But our minds often label money based on its intended use.
One example is gift cards. When people receive gift cards from a specific retailer, they are much more likely to spend it on something highly representative from that brand, or on a more expensive item than originally intended.
So, if money doesn’t have labels and is interchangeable, why would anyone be willing to pay more than twice the price for an item in one location over another?
Often, it comes down to the environment and situation. Our mind’s subjective view of money’s value is highly influenced by our environment.
You’re more likely to pay a higher price for a bottle of soft drink from a fancy bar, than buying the same drink from a corner shop. But it doesn’t matter where you consume the drink, you’ll still pay more for it if you feel the environment or situation warrants the additional cost.
This suggests that our definition of a reasonable price is very flexible and can vary widely depending on the situation.
Understanding the limitation of your own mental accounting and the values you attribute to money will help you when setting up your budget and savings goals. The key thing is to understand that all money is equal. Once you can do that, you’ll be much more likely to make more rational, less emotionally driven decisions with your money.
Here’s 4 simple ways to start viewing money objectively: