You might never have heard about Mental Accounting, but trust me, you have experienced it. You just haven’t realised it yet. Mike LeGassick explores the way we look at money.
More formally, mental accounting refers to the inclination to categorise and handle money differently depending on where it came from, where it is kept, or how it is spent. To understand how natural, and tricky, this habit can be, consider the following scenario.
In reality, £100 in roulette winnings, £100 in salary, and a £100 found blowing around in the wind should have the same significance and value to you, since in each instance, they could buy the same number of downloads from iTunes or the same number of lattes at Costa. Likewise, £100 kept under the mattress should create the same feelings or sense of wealth as £100 in your bank.
If money and wealth are interchangeable, there should be no difference in the way we spend gambling winnings, inherited money or our disposable income from our hard-earned salary. Every financial decision should result from a rational thought of its effect on our overall wealth.
The problem is that this is not easy to be aware of. I know this to be absolutely true through my 20 plus years’ experience as a Lifestyle Financial Planner.
As with most things, there is always the exception. Maybe you are an accountant!
Imagine you are about to purchase a new table for your living room for £100 and as you are about to buy it, you do a quick search on your mobile phone and realise that you can buy the very same table just a mile down the road for £75. Would you walk the mile to make the £25 saving? After all, it is a 25% saving.
Now imagine you are buying a new kitchen for £8,000 and, once again, as you are about to purchase, you realise that you can buy the very same kitchen a mile down the road for £7,975. Would you still walk down the road to save £25?
If you walked the mile to save on the table, but couldn’t be bothered to walk to make the same saving for the kitchen, then this is irrational behaviour. You have simply compared, rationalised and justified to yourself that a 25% saving on the table compared to a fractional saving on the more expensive item, the kitchen, is not worth the effort, however, it is still a £25 saving on both items. For the record, the £25 in question in this example represents a 0.312% saving on the £8,000 kitchen and thus, your brain says ‘it’s peanuts. What’s the point in walking a mile to save such a trifling amount?’ The only logical reason you wouldn’t walk the mile to make the saving would be if you could earn more money in the time it would take to walk the mile to make the £25 saving. In this case, it would be futile and not financially viable. So, unless you are Bill Gates, you have just cost yourself a £25 saving.
So the next time you are spending some of your hard earned cash, remember that £25 is £25!