Why We Make Dumb Financial Decisions, and How to Think Differently

Image: Bad Money Decision
Thomas Galvez under Creative Commons

Do you think you’re pretty clear-headed about money matters? Unfortunately, research suggests that your financial decisions are not nearly as rational as you think. In fact, you are probably a victim of your own “mental accounting.”

Behavioral economists devise experiments to see how we actually make our financial decisions. In a previous post on subliminal sales techniques, we looked at a few of the tricky ways companies apply the results of this research to influence you. Now, we’ll look at what science says about one of the ways you trick yourself into bad financial decisions.

Most of us use arbitrary, non-rational categories to mentally organize our money. In behavioral economics, this is referred to as mental accounting. It can be an expensive habit, or, once you understand the process, you can use it to your own benefit.

An Expensive Habit: “My Money” vs. “Found Money”

One of the most common examples of mental accounting is how most of us treat “found” money differently from earned income. In other words, if we get a monetary gift or win a cash prize, we tend to think of it as a special category of money. We splurge or buy things we wouldn’t normally buy with our “hard-earned money,” even though all money is essentially the same once it is ours.

This thought process is particularly damaging in the case of lottery winners who blow through millions and go bankrupt.

I saw plenty of examples of irrational mental accounting during my days as a blackjack dealer. When players were ahead for the night, they would decide they were playing with the “house’s money,” and make more reckless bets.

It made no sense at all. They were free to leave with the money. They could have used it in any way that their “other” money was used. They could at least have played normally. But having put it mentally into a different category than “my money,” they went crazy, and typically lost all of their winnings.

Irrational Financial Decisions

Here’s another example of mental accounting from a study of New York City taxicab drivers. The drivers paid a fee for their cabs for the day and could choose how long to work. The rational strategy would be to work long hours on busy days and less on slow days, to make the most money for the time worked. Think about it for a moment: you can only work so much, so if you want to work 40 hours in a week, doesn’t it make sense to work the hours that pay the most?

Interestingly, many cab drivers did the exact opposite because of their mental accounting. Specifically, they had a benchmark in mind for how much they should make in a day, and when they reached that amount, they quit. The result was that when tips were rolling in they quit early, while on slow days they worked up to 12 hours. They set themselves up to make the lowest possible hourly wage.

Do you think you’re not subject to this kind of mistake? Think again. Look closely and you’ll probably find personal examples of mental accounting.

Your Beneficial Mental Accounting

Look, it really is crazy to call gambling winnings “house money,” as though it belongs to the casino and you have to return it. And if you’re a cab driver, you shouldn’t choose a schedule that makes the lowest wage possible. So it makes sense to look for your own mental accounting and challenge it to avoid bad decisions. But is it possible that some of your mental accounting can benefit you?

Let’s consider tax refunds. Yes, you might mentally account for your big refund as a special category of money and spend it for frivolities. But some people mentally categorize these windfall chunks of money as opportunities to pay down debts. In fact, a recent poll showed 21% of people planned to do exactly that with their income tax refunds.

Here’s another trick of mental accounting that can help you out. Some people think of their checking account as empty when it gets down to $300 or $500 or $5,000. That remainder is “untouchable” money, meant only for emergencies. In addition to preparing them for the unexpected, thinking of that $500 mark as $0 probably prevents accidental overdrafts.

Once you’re aware of the mental accounting going on subconsciously, you can correct your errors — and maybe even use the process consciously to help you save money and build your wealth.

Your Turn: Can you think of examples of “mental accounting” from your own life? What were the results?

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