A basic premise of traditional economics is that people think and behave rationally with respect to how they deal with money. However, as behavioral economists are quick to point out, this is often not true. One example of how people behave irrationally is a psychological phenomenon known as mental accounting–basically, the process by which our mind organizes and evaluates our financial activities. Mental accounting explains, for example, why we might be likely to use a raise in our salary to increase retirement savings whereas we use a one-time bonus of the same amount for a new TV or a big vacation. The manner in which we receive money and where it is located can influence decisions about how we spend it. The problem with this phenomenon is that by failing to behave rationally with our money, we can sometimes make poor financial decisions and fail to make good use of the assets we have.
Pitfalls of Mental Accounting: A Young and Hungry Dustin Hoffman. Actor Gene Hackman enjoys telling a story about him and Dustin Hoffman when they were new to the entertainment business (see below). While Hackman was visiting his small Pasadena apartment, Hoffman asked if he could borrow some money. Hackman was happy to oblige but noticed jars full of money on the window ledge. There was money in the jars labeled “rent,” “entertainment,” “phone,” “electric,” but none in the jar labeled “food.” When Hackman suggested that Hoffman take some money out of the other jars for food, he exclaimed, “I can’t take the money out of the other jars!” Professor Richard Thaler, an expert on mental accounting, likes to cite this story as a great example of how people do not treat money as fungible, or freely interchangeable. They might eat rice and beans for a week because there’s no money left in the food jar, even though they could take some money from the entertainment jar without any negative consequence.
*Warning: this video contains foul language.
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Pitfalls of Mental Accounting: Other Real Life Examples. We see this phenomenon regularly in our work as well. In some cases, clients carry credit card debt because they do not have enough money in their checking accounts to cover a significant unexpected expense. They may have assets in a taxable investment account that could be used to pay off the debt and avoid exorbitant interest and penalties, but they don’t consider using that money because it was initially saved for a different purpose. In other cases, retired clients express a preference for investments that pay interest or dividends (because they like receiving an “income” to help fund their lifestyle), even though doing periodic sales of investments that grow and appreciate over time could provide the same regular income and could improve their tax situation and long-term financial prospects.
One of the benefits of working with a financial advisor is to have a partner in your financial life who does not compartmentalize your assets and liabilities in the same way and who evaluates financial decisions less emotionally and more objectively in order to help you achieve your financial goals.
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