Money in any form is money, honey!

It’s mental accounting that makes you categorise it and treat it differently

MUMBAI: Legend has it that, on her wedding night, she had disappeared and appeared only in the morning. Polite enquiries had revealed that the night had been spent at a local casino, where she had almost gambled her way to glory.

She had stolen Rs 500 from her husband’s wallet and headed straight for the casino. Once inside the casino, she went straight to the roulette counter and bet the entire amount on number 13. And as luck would have it, 13 it was. As the night went along, she kept winning and kept betting the entire amount on 13. In the wee hours of the morning, she had won Rs 5 lakh and was ready to leave with the booty. 

As she was about to leave, she decided to play the game again. One last time. If she wins this time around as well, she could get up to Rs 25 lakh. And she thought this was worth the risk. She bet on 13 again. As the roulette went round, and the ball jumped from one number to another, her hearbeats increased. When the roulette stopped, the ball was on number 14.

After returning home, she sobbingly narrated the entire incident to her husband. And he had told her, “But darling, all you lost was Rs 500?” Did she? Or was this mental accounting at work?

Richard Thaller, a pioneer of Behavioural Economics, coined the term mental accounting, and defined it as “the inclination to categorise and treat money differently, depending on where it comes from, where it is kept and how it is spent”.

So gamblers who lose their money feel that they haven’t lost anything, in spite of the fact that they would have been richer had they stopped playing when they were ahead.

This is not the only consequence of mental accounting. As Gary Belsky and Thomas Gilovich point out in their book, Why Smart People Make Big Money Mistakes and How to Correct Them, “By assigning relative values to different moneys that, in absolute terms, have the same buying power, you run the risk of being too quick to spend, too slow to save, or too conservative when you invest — all of which can cost you money.”

The general tendency is to spend the money one receives unexpectedly (gift, bonus, etc) faster than one’s own hard-earned money. As Belsky and Gilovich point out, “Consider tax refunds, for example. Many people categorise such payments from the government as found money —  and spend it accordingly — even though a refund is nothing more than a deferred payment of salary. Forced savings, if you will. If, on the other hand, those same people had taken that money out of their paycheck during the course of the previous year and deposited it into a bank account or a money market mutual fund, they would most likely think long and hard before spending it on a new suit or Jacuzzi.” The same logic works when individuals receive a bonus or arrears.

What also matters in these cases is the size of the refund.An individual is more likely to spend Rs 1,000 received as a tax refund vis-a-vis Rs 10,000 received as tax refund. When the tax refund is large enough, then the human tendency is to categorise it into a long-term mental account and, hence, save it.

Mental accounting also leads to this phenomenon where individuals “integrate losses”. As Belsky and Gilovich explain, “When you incur a loss or expense, you prefer to hide it by burying it within a bigger loss or expense.”

An individual may not buy an expensive stereo system for his old car, but is more likely to do the same while buying a new car. This is because the pain of buying an expensive stereo system is neutralised by the bigger pain of buying a new car.

And businesses understand this very well and tend to use it to their advantage. As Belksy and Gilovich point out, “That’s why consumer electronics stores sell extended warranties or service contracts with major purchases. Would anyone buy what is essentially an insurance policy for a CD player or TV at any other time? And that’s why insurance agents sell exotic “riders” at the same time they’re pushing broader policies.”

(The example is hypothetical)