Our brain can choose how we subconsciously view money. When emotion overtakes reason, we don’t always make the best financial decisions. Here we tell you about mental accounting to make sure it doesn’t hurt your finances.
We’ve all heard mathematics are an exact science. But when it comes to money, a 10 euro note or dollar bill might not hold the same value for everyone. Why? Because of “mental accounting”.
US economist and 2017 Nobel Memorial Prize in Economic Sciences winner Richard Thaler has the theory that our emotions, and not rational thinking, shape the way we spend, save and invest money. In other words, our brain makes subjective financial decisions based on our feelings, preferences and convictions. If we think more objectively, we can avoid harming our financial health.
What's mental accounting all about?
Antonio and Luis are having lunch together, and both have 50 euros to pay their share of the bill. Antonio's is from his salary, but Luis’s came from selling an old video game console on a collaborative economy app. Antonio keeps a keen eye on the price of each dish and is careful not to blow all his budget. Luis, however, orders without so much as a glance at the listed prices and is happy to spend all 50 euros.
Though Antonio and Luis are both holding the same amount (the “actual” value), their decisions on what to spend stem from how each of them views its value (the “subjective” value). According to Thaler, that's because of automatic “mental accounting”: Antonio and Luis each feel differently about how they earned their money, the situation they’re in, their personal finances and the effort they had to make to earn their money. Antonio is more apprehensive to spend his money because of how much he had to work for it; but Luis is quick to dole his out, because he didn't work so hard to earn it.
The thought of losing money tells our brain how to value something. We’re more likely to wait in the rain for a concert if we’ve already paid for the ticket; but, if the ticket is a gift, our brain will tell us it’s OK to skip the concert since we won’t lose any money. Nonetheless, the objective value of the ticket is the same in both cases.
Because our brain is more focused on the result and, especially, the reward of financial decisions, it tends to simplify them for us with mental accounting, a form of financial bias closely related to the nudge theory.
Tips to resist mental accounting
Because mental accounting causes us to value money arbitrarily, we're more likely to misspend it. The first step to overcoming mental accounting (and other financial biases, like the Prodigal Son Paradox, as explained in Spanish on Santander Consumer España’s blog Tu Futuro Próximo (“Your near future”)) is to learning how to spot it.
Drawing up a budget can be useful. It's without doubt one of the best ways to stay in tune with our financial health. A budget will help us see how our spending affects our bottom line, regardless of where or how we got our money.
Because we tend to spend money we haven’t had to earn (like from a tax return or a prize), we should take the time to think about how best to use it, without impulse.