Mental Accounting

Mental Accounting

Alarm clocks and Christmas clubs are external devices people use to solve their self-control problems. Another way to approach these problems is to adopt internal control systems, otherwise known as mental accounting. Mental accounting is the system (sometimes implicit) that households use to evaluate, regulate, and process their home budget. Almost all of us use mental accounts, even if we’re not aware that we’re doing so.

The concept is beautifully illustrated by an exchange between the actors Gene Hackman and Dustin Hoffman that you can find online.3 Hackman and Hoffman were friends back in their starving artist days, and Hackman tells the story of visiting Hoffman’s apartment and having his host ask him for a loan. Hackman agreed to the loan, but then they went into Hoffman’s kitchen, where several mason jars were lined up on the counter, some stuffed with money. One jar was labeled “rent,” another “entertainment,” and so forth. Hackman asked why, if Hoffman had so much money in jars, he would possibly need a loan, whereupon Hoffman pointed to the food jar, which was empty.*

According to economic theory (and simple logic), money is fungible, meaning that it doesn’t come with labels. Twenty dollars in the rent jar can buy just as much food as the same amount in the food jar. But households adopt mental accounting schemes that violate fungibility for the same reasons that organizations do: to control spending. Most organizations have budgets for various activities, and anyone who has ever worked in such an organization has experienced the frustration of not being able to make an important purchase because the relevant account is already depleted. The fact that there is unspent money in another account is considered no more relevant than the money sitting in the rent jar on Dustin Hoffman’s kitchen counter.

At the household level, violations of fungibility are everywhere. One of the most creative examples of mental accounting was invented by a finance professor we know. At the beginning of each year, he designated a certain amount of money as his intended gift to a local charity called United Way. Then if anything bad happened to him during the year—a speeding ticket, for example—he mentally deducted the fine against the United Way gift. This provided him with a form of “mental insurance” against minor financial mishaps.*

You can also see mental accounting in action at the casino. Watch a gambler who is lucky enough to win some money early in the evening. You might see him take the money he has won and put it into one pocket and put the money he brought with him to gamble that evening (yet another mental account) into a different pocket. Gamblers even have a term for this. The money that has recently been won is called “house money” because in gambling parlance the casino is referred to as the house. Betting some of the money that you have just won is referred to as “gambling with the house’s money,” as if it were somehow different from some other kind of money. Experimental evidence reveals that people are more willing to gamble with money that they consider house money.4

This same mentality affects people who never gamble. When investments (say, in the stock market) pay off, people are willing to take big chances with their “winnings.” For example, mental accounting contributed to the large increase in stock prices in the 1990s, as many people took on more and more risk with the justification that they were playing only with their gains from the past few years. The same thing happened with speculative real estate investors a few years later. Similarly, people are far more likely to splurge impulsively on a big luxury purchase when they receive an unexpected windfall than they are with savings that they have accumulated over time, even if those savings are fully available to be spent.

Mental accounting matters precisely because the accounts are treated as nonfungible. True, the mason jars used by Dustin Hoffman (and his parents’ generation) have largely disappeared in modern economies (though they remain in some poor countries). But many households continue to designate accounts for various uses: children’s education, vacations, rainy day, retirement, and so forth. In many cases, these are literally different accounts, as opposed to entries in a mental ledger. The sanctity of these accounts can lead to seemingly bizarre behavior, such as simultaneously borrowing and lending at very different rates. These issues are discussed further in Chapter 11 of Nudge.

Of course, many people do not suffer from an inability to save. Some people actually have trouble spending! If their problem is extreme, we call such people misers, but even regular folks can find that they don’t give themselves enough treats in life. We have a friend named Dennis who adopted a clever mental accounting strategy to deal with this problem. At some point Dennis started collecting Social Security payments, although both he and his wife were still working full-time. Since he had been a good saver over the years (in part because his employer has a mandatory and generous retirement plan), Dennis wanted to be sure he would do the things he enjoys (especially trips to Paris with lots of fine dining) while he was still healthy and not be put off by the expense. So he opened a special savings account into which his Social Security checks were directly deposited. He designated this to be a “fun account.” We hear that a spiffy electric bike was the latest purchase from that account.

A near sacrosanct “rainy day” account can protect emergency savings, while an “entertainment and fun” account can give a reluctant spender permission to enjoy some money. Governments designing savings policies can also consider how earmarking money in a mental or real account affects the temptation to spend it.