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ShareMumbai: Do you plan to gamble this Diwali? Well just be sure that you don't fall into the mental accounting trap. Now what exactly is mental accounting? Let us say you started playing teen patti (a game of cards or Flash as it is called in English) last Diwali. Initially being the conservative guy that you are, you bet Rs 1,000. Luck was on your side that day, and you kept winning till you had accumulated around Rs 11,000. Your gains then stood at Rs 10,000 for the night.
Then in the heat of the moment, you bet Rs 10,000, your total winning for the night on a single game. But your luck ran out that moment and you lost the game. With that went the entire Rs 10,000 you had won for the night. After that you consoled yourself. "I haven't lost any money. Well I still have the Rs 1,000 I started with."
If you had gone through this situation last Diwali, well then you had fallen into the mental accounting trap. Richard Thaler, a pioneer of behavioural economics, coined the term "mental accounting", defined as "the inclination to categorise and treat money differently depending on where it comes from, where it is kept and how it is spent".
Thaler along with Cass Sunstein explains this in his book Nudge -- Improving Decisions About Health, Wealth and Happiness. "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," write the authors.
The gamblers call their winnings 'house money'. As the authors write "The money that has recently been won is called 'house money' because in the 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 was, somehow, different from some other kind of money. Experimental evidence reveals that people are more willing gamble with money that they consider house money."
This effect is even seen at work when stock markets are on an upside. Thaler and Sunstein, give the example of the late 1990s when the world was seeing the dotcom bubble. "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 last few years," they write.
Same is the case when people receive an unexpected windfall gain from somewhere. As the authors write, "People are far more likely to splurge impulsively on a big luxury purchase when they receive an unexpected windfall than with savings that they have accumulated over time, even if those savings are fully available to be spent."
Another interesting example that authors talk is about individuals who have huge debts on their credit cards and at the same time money lying in their savings account. "David Gross and Nick Souleles (2002) found that the typical household in the sample of Americans had more than $5,000 in liquid assets (typically in savings accounts earning less than 5% per year) and nearly $3,000 in credit card balances, carrying a typical interest rate of 18% or more." Now wouldn't it have been much simpler to pay off the credit card debt instead of paying such a high rate of interest on it? Yes, but mental accounting was at work and more than that this behaviour may "not be as stupid as it looks".
As the authors write, "Many of these households have borrowed up to the limits that their credit cards set. They may realise that if they paid off the credit card debt from the savings account, they would soon run up the cards to their limits once again. (And credit card companies, fully aware of this, are often more than willing to extend more credit to those who reached the limit, as long as they aren't yet falling behind on interest payments."
Well if you still haven't understood what mental accounting is all about, here is another example.
"The concept is beautifully illustrated by an exchange between Gene Hackman and Dustin Hoffman. 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 each containing money. One jar was labelled 'rent,' another 'utilities,' and so forth. Hackman asked why, if Hoffman had so much money in jars, he could possibly need a loan, whereupon Hoffman pointed to the food jar, which was empty."
