Mental Accounting, Rats, and Cats

By Ben Dolan, CFP®

Those that know me might assume I spend all my time reading publications on finance and markets, and that is where I spend most of my reading hours. However, in the era of click-bait nastiness and fearmongering, I’ve slowly gravitated to the lighthearted A-HED section of the Wall Street Journal, which publishes oddball and quirky news items meant to be a break from the doomsday that is rest of the news (the name is a tongue-in-cheek reference to the most important story of the day, or the A-Headline). Recent stories in this section included the new Rat Czar in NYC and cat curfews in Australia.

The May 4th A-HED article piqued my interest given its connection to another interest of mine: behavioral finance. The headline, by Tara Weiss, was “You’re About to Pay $300,000 for College. What’s Another $3,000 in Campus Swag?”. In other words, if I’m spending $300,000 on college for my child, what’s the big deal if I spend another $3,000 on swag for her and the rest of the family? This headline encapsulates one of the major behavioral mistakes many of us make on a regular basis: mental accounting.

Gary Belsky and Thomas Gilovich outline the many harms of mental accounting in their book Why Smart People Make Big Money Mistakes and How to Correct Them. Giving credit to the University of Chicago’s Richard Thaler, Belsky and Gilovich define mental accounting as “the tendency to value some dollars less than others and thus to waste them” (pg 33). They provide an excellent (and self-deprecating) example of the harms of mental accounting:

As a struggling college student in the early 1980s, Gary had decided against replacing his car radio with a new cassette deck, for the simple reason that he couldn’t justify the $300-$400 it would cost to buy the new piece of equipment. In his last year of college, though, Gary finally bought a new car (with the aid of a hefty loan). The cost: $12,000 – plus another $550 for a cassette deck to replace the optional AM/FM radio. Three months earlier – before his car broke down – Gary had shopped for cassette decks and deemed $300 too extravagant. Yet a car salesmen had little trouble convincing him to spend almost twice that amount for the same product, even though Gary’s finances were presumably more precarious now that he had to make $180 monthly payments for the next four years.

The main culprit, of course, was mental accounting - $550 seemed to have less value next to $12,000. But also contributing to Gary’s decision was the subconscious preference, shared by most people, to “integrate losses.” Translation: When you incur a loss or expense, you prefer to hide it from yourself by burying it within a bigger loss or expense, so that the pain of spending $550 for cassette deck was neutralized to great extent by the larger pain of spending twelve grand.  

The downside of not recognizing our tendency to integrate losses can cause us to be too quick to spend, or too slow to save. Mental accounting can also cause us to be too conservative when we invest, thereby risking running out of money late in life when we need it most. I’ve yet to meet a client or prospect that has a goal of being financially dependent on others in retirement.

To establish good financial habits, we must first understand our bad financial tendencies and make the necessary adjustments.

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Ben Dolan and Michael Foster are investment advisor representatives of Dolan Capital Advisors a North Carolina state-registered investment adviser. Investment advice offered through Dolan Capital Advisors, Inc.