Tuesday, April 26, 2011

Mental Accounting

Why is it that some people have such a hard time saving money? One possibility is the use and abuse of mental accounting. Mental accounting refers to the theory which attempts to explain the way people sometimes subjectively frame monetary transactions. It looks at the inclinations people have to handle money differently depending one how it was acquired, where it is kept and/or what it's intended purpose is.

The simplest example of this would be how money won is treated differently than money earned. Say for instance you go to the casino with some friends and you take $50 with you to gamble with. You're down to your last $1 and you drop it in the slot machine and luckily win $300. So now what? Do you keep gambling? Buy a round of drinks for all of your friends? Contribute it to your IRA? Most people would continue gambling the money until all or most of it was gone. But why? The purchasing power of the $300 you won is no different than the $300 you had to work two or three days to acquire. But mentally it is treated differently. This is quite apparent if you ask yourself how much stress would you feel if you lost $300 cash you worked for vs $300 you won then lost at the casino.

Another example would be how purchase size can effect our decisions. Say for instance you are out shopping for a new coffee maker. You find the one you want for $70 at the store when a person comes up to you and says that you can get the same coffee maker on sale at a store 20 miles away for only $35. Would you go to the other store? Of course, that is a 50% savings, who wouldnt. But lets change the scenario and say that instead of a coffee maker, you're shopping for a new couch. You're at the store and you find the one you want for $2000. Someone comes up to you and says you can get the same couch at a store 20 miles away for $1965. Would you go to the other store or just buy the one at the store you're at? What if it was a car selling for $15000 at the place you're at and $14965 at the dealorship down the road? As you can see, as the purchase price goes up the $35 seems to be less valuable. But of course purchasing power of the saved $35 is the same no matter how it was saved.

Now I'm not trying to say that we need to stop using mental accounting and instead be completely rational about every single financial transaction we engage in. But it is something to ponder and it would probablly do us good to occasionally do a little self analyzing to determine how we go about making our decisions.

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