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