A behavioral economics thought experiment:
A woman spends $160 on two theater tickets, only to arrive at the theater and discover that she has lost her tickets. Does she spend another $160 on new tickets?
A variation: The same woman brings $160 in cash to the theater with the intention of spending that cash on two tickets, only to discover that the cash is missing. Does she use her credit card to purchase tickets instead?
When presented with the first scenario, the vast majority of people presume the woman would just skip the play, having lost her tickets. When presented with the second scenario, however, more than half believe the woman would go ahead and purchase new tickets. In both scenarios the woman is already out $160, so why the difference?
The ledger in your mind
Quartz recently reprinted a fascinating section from Claudia Hammond’s book Mind over Money, in which the journalist explains economist Richard Thaler’s theory about “mental accounts.” In essence, the reason why people are more inclined to believe that it’s okay to purchase new tickets when the cash was lost instead of the original tickets is because we sort our money into mental categories. Instead of thinking of purchases holistically, we view our expenses relative to other expenses in the same category.
In the first scenario, the already-purchased tickets came out of the woman’s “entertainment” account. Therefore, buying another set of tickets would feel like overspending within that category (the $160 probably felt extravagant - $320 would be outrageous). In the second scenario, even though the cash was earmarked for those tickets, because it was still cash the money feels like it belongs in a more broad “general expenses” category. The “entertainment” budget is still intact, so it feels okay to make the purchase.
In other words, it’s all the same money, but how we perceive certain expenses changes drastically depending on how we mentally categorize them.
Mind your categories
The danger with mental accounting like this is that it can distort our perception of value and sound investment. Even separating “food at home” and “food away from home” can lead to poor purchasing decisions. Consider that while you may identify certain “food away from home” purchases as being good values relative to their category, the majority of purchases within that category are likely to compare poorly to purchases in the “food at home” category.
Chances are good you’ve already created a temporary mental account for the holidays. As such, you’re more likely to think about your holiday spending in relation to last year’s holiday, rather than in relation to the rest of your spending during the year. This can lead to making decisions that feel right at the time, but don’t really fit your overall budget.
The key is narrowing down your mental accounts and broadening the way you compare expenses. Circling back to that opening thought experiment, it shouldn’t matter how the woman loses the $160. The question is – can she really afford to spend another $160 on tickets? If the money is there and the expense fits within her budget and her present goals, then she should go for it. If not, then she’ll have to pass.
We do ourselves no favors by misrepresenting our financial situation in those moments. So be careful how you use mental accounts and remember that however you spend it, it’s all your money and there’s only so much of it to go around.