Jed Cohen

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Mental Accounting

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So I’m starting to pay back my student loans. As a result, I decided to take stock of where I am financially. I know that I’m better off than the average NYU student in terms of debt versus savings (thanks mom and dad), but I have to admit that I wasn’t quite as involved in the borrowing process as I should have been four years ago. So I turned to Mint to get a sense of my financial “health.” According to my profile there I’ve been a member for 416 days, but I haven’t used it much. Yes, I would get a monthly summary, and I’d get e-mails if I made any unusual purchases (something I wish my credit card company would do). But I’ve generally pretty good at not spending more than I earn, so I didn’t need to track budgets or compare credit card programs. Now that I’ve been taking a much more active role in my finances, I’ve been thinking more about how my mind views my savings more than I normally do.

Our minds play tricks on us.

On a semi-regular basis I go to the ATM and withdraw some cash. When I do this, I unconsciously begin to differentiate the cash from my savings, even though it is still part of my total net worth. My mind has placed it in a different account, much like a mental balance sheet. In a way I view that cash as “spent” since it’s no longer in my bank account – which is not such a great thing because I won’t approach spending it with the same scrutiny that I do the money in my checking account.

If you think about it, you might do the same thing when you use your credit card. Whenever you swipe your card, you technically loose money. Yet you may not feel that loss until you pay your credit card bill.  Credit cards, loans, and a whole bunch of other modern financial tools divorce the act of purchasing from the act of paying.

Here’s some other examples:

  • Pennies a day – Framing a large long term purchase/subscription as “x cents a day” or “as much as your daily cup of coffee” is more effective than framing it as a cost per year.  This is because we place them in a kind of petty cash mental account.
  • Length of time is a factor – NYC cab drivers rent their cabs in 12 hour shifts. They tend to quit early on busy days because they make up their costs sooner and stay out longer on busier days. This is the exact opposite of what they should do; on busy days they’ll make more if they stay out longer, while they should save their time on slow days.  This occurs because cab drivers look at their earnings on a per day basis instead of on a longer time frame.
  • Bonus versus rebate – In 2001, the “Economic Growth and Tax Relief Reconciliation Act” gave $38 billion back to American taxpayers in $300-600 rebates to stimulate the economy.  However, only 22% actually spent it – the rest saved it or payed back debt. But there is some evidence to suggest that a greater percentage of people would spend it if it was positioned as a bonus (a gain) instead of a rebate (a returned loss).

I could go on.

There are a lot more examples of how mental accounting (and other psychological phenomena) makes us act in irrational ways. One of the best ways to counteract them is to understand and acknowledge them. Tools like Mint leverage technology to help us think smarter and maybe overcome some of the quirks of our own minds. Which is both cool and disconcerting, isn’t it?

Written by Jed

January 5th, 2010 at 9:59 am

Posted in psychology

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