By definition, all dollars are the same and equal. Traditional
economics holds that people act rationally and treat all dollars
the same; but the reality is that people actually treat money
differently depending on where it comes from. Behavioral
economics blends the fields of economics and psychology to
explain these kinds of irrational biases in behavior.
"The Casino's Money" or Your Money?
Question: If you started gambling in a casino with $500,
proceeded to win $2,500, and then lost the entire sum, how much
money have you lost gambling? Many people feel that they have
lost $500, and casinos benefit enormously from this phenomenon.
The reality is that you have actually lost $3,000 - the original
$500 and the $2,500 in winnings. The concept of mental accounting
refers to the mind's tendency to place different values on
dollars depending on where the dollars originate, and is the
reason that people tend to treat the $2,500 in winnings
differently from the original $500.
In fact, the idea that money would still be "the casino's money"
after you have it in your possession is fundamentally flawed. Yet
mental accounting causes people to treat the $2,500 in winnings
as "found" money that is somehow not "worth" as much as the
dollars that were present at the beginning of the game. And since
the $2,500 is thus considered to be "found" money or "the
casino's money," it is common for people to continue gambling
instead of quitting while ahead.
Tax Refunds are Your Wages, Not Gifts from the
Government
Mental accounting is well documented, and casinos are not the
only entities that benefit from it. People also treat tax refunds
differently than other "kinds" of dollars. Tax season is upon us,
and you will soon see newspaper advertisements for "tax refund
sales." Compared to spending money that has been set aside in
savings or investment accounts, many people are more likely to
spend money from tax refunds on large purchases of discretionary
items such as furniture and electronics. Remember that your tax
refund is simply a return of a portion of your wages, nothing
more. $1,200 in tax refund money is the same as $1,200 that you
saved by setting aside $100 each month for a year. So, the next
time you feel tempted to make a large purchase with money from
your tax refund, ask yourself if you would also make the purchase
with dollars from your savings or investment accounts. If the
answer is no, then consider holding off on the purchase, because
the odds are that you have fallen victim to mental accounting.
The Cost of Mental Accounting for Investments
Spending is not the only type of behavior affected by mental
accounting. Investment decisions are also affected when certain
dollars are considered to be so "sacred" that little or no risk
should be taken with them. This can happen with an inheritance,
as investors that normally favor stocks may feel compelled to
confine inheritance dollars to low yielding savings accounts and
CDs. This decision to invest inherited assets differently is
based on fears that "losing Grandpa's money" would be more
painful than losing "your own" money. Yet, a $20,000 inheritance
placed in low yielding savings accounts that average 3 percent
interest over a period of 20 years would amount to just over
$36,000. That same $20,000 inheritance invested in the stock
market would likely benefit from an average return of at least 8
percent per year over the 20 year period, and grow to over
$93,000. In this example, the cost of mental accounting is
approximately $57,000.
Many Americans also make similar mistakes when investing money in
employer sponsored retirement plans like 401(k) plans. Mental
accounting leads many investors to seek the utmost safety for
their retirement dollars by investing only in asset classes with
little risk that provide meager returns. The irony is that, by
seeking safety in the short term, these investors are actually
increasing the long-term risk that they will not have enough
assets to retire comfortably.
1
Most investors with relatively long time horizons should take
some risk in their retirement plans so they realize higher
returns and achieve the growth necessary to fund a secure
retirement.
If you need help avoiding the pitfalls of mental accounting or
finding the right asset mix for your retirement plan, consider
consulting a financial planner with the experience and expertise
necessary to guide you.
FPA member David Zuckerman, CFP®, CIMA®, is Principal and
Chief Investment Officer at Zuckerman Capital Management, LLC in
Los Angeles, Calif. He serves as CFP Board Ambassador and
Director at Large for the Los Angeles chapter of the Financial
Planning Association.
1
Gary Belsky & Thomas Gilovich, Why Smart People Make Big
Money Mistakes and How to Correct Them (Simon & Schuster,
1999), 37-49