MENTAL ACCOUNTING - Definitions, Causes, Risks, Advantages & Debiasing
Mental accounting describes the way that we mentally organize, evaluate, and keep track of our financial choices (Thaler,1999). One of the most important finding regarding mental accounting is that while money doesn't come with any labels, we put mental labels on it by categorizing funds into different accounts, and then treat money in these accounts as distinct and not interchangeable (Hossain, 2018). For example, say you bought a movie ticket worth $20, in advance. But on the day of show, you lose the ticket. You were supposed to go alone. Would you buy a new ticket or drop the plan? Probable depends on how much you were looking forward to the moview right? Now, imagine that you didn't buy the ticket in advance, but you plan on going for the show and buying a ticket at the theatre. On the day of the show, you unfortunately lose $20. Would you cancel the movie plan? Probably not right - the two things seem unrelated. But think about it - in both cases you lose $20, whether in cash or kind, and are without a movie ticket on the day of the show. But as you can now see, we have different mental accounts for cash and kind, and we don't treat $20 in cash the same as $20 in kind.
We categorize funds in many different ways, such as based on their origin. For example a bonus payment or an unexpected income like a lottery win is considered a windfall gain, and we're more likely to spend such funds than regular income.
We also categorize funds by their intended use. For example, we set budgets for various expenses like food, entertainment, health, etc. and we segregate funds for these such that they can't be used interchangeably.Sometimes, based on the origin of funds, we may assign them to a related budget category. For example, we're more likely to spend windfall income on luxury goods, and regular income on more essential goods.
And lastly, we categorize funds by grouping financial choices or decision outcomes together to form an account. For example, while deciding the budget for a purchase, we may consider only the purchases made on that shopping trip or all the purchases made across all stores during the month. This is known as choice bracketing, and we may bracket narrowly by considering a smaller set of choices or broadly by grouping together a larger set.
One of the common ways we bracket choices is by grouping funds based on the timing of their use. Temporally distant outcomes are more likely to be put into different mental accounts while temporally close outcomes are more likely to be integrated into the same account. Temporal bracketing also plays a large role in determining the period over which we evaluate and reconcile our mental accounts e.g., daily, monthly, etc. (Zhang & Sussman, 2018).
Another key finding about mental accounting is that we experience pain or displeasure while making a payment, which is similar to the pain of losing money. But while making a purchase, this pain is balanced out by the pleasure of consumption. And when we pay in advance, we think of the future consumption to offset the pain of payment. When we actually consume something we've already paid for, we don't have to think about payment at all, making the consumption feel almost free - which is, as you would've noticed, paradoxical (Prelec & Loewenstein, 1998).
Cognitive causes are the psychological mechanisms that explain the bias. It is likely that no one of the multiple explanations can explain every instance of the bias, and each explanation is valid in some cases and invalid in others.
Mental accounting has many similarities with how we categorize objects and events more generally. Categorization is a way of organizing information into groups based on commonalities. In general, the more similar two choices are perceived to be, or closer they occur to each other, the more likely they are associated with the same category (Evers et al., 2021). We categorize time, food consumption and even social behaviors. E.g. a recent study found that individuals who helped others in a particular social category were less likely to help the same social category the next day, as if they were working with budgets of help for different categories (Peetz & Howard, 2020).
Next, we tend to track and evaluate payments and consumption separately. We track payments in terms of the perceived value of the 'deal'. It is the difference between the amount paid and the 'reference price' that we expect to pay (Prelec & Loewenstein, 1998). The reference price is typically based on the memories of past paid or seen prices, and more recent prices influence it more. Sales and discounts drive purchase by making the deal more attractive (Baucells & Hwang, 2017).
We track benefits of consumption in terms of the value of the good obtained relative to its price. It is the pleasure anticipated or derived from the consumption minus the pain of paying. If the payment and consumption occur close to each other, the consumption will be less pleasurable than if they are separated in time. This is the reason that we often prefer to pay in advance and consume later (Zhang & Sussman, 2018).
Parietal lobe seems to play a key role in categorization while DLPFC is involved in budget-based decision-making (Freedman & Assad, 2011; Grossman et al., 2002). Sub cortical regions like Striatum, amygdala and insula are involved in tracking the value of financial choices and outcomes in terms of pleasure and pain (Haller & Schwabe, 2014; Zeng et al., 2013).
For the bias to be passed down genetically or culturally to us from our ancestors, it must be beneficial in certain conditions.
Firstly, categorizing funds helps in quick recall and judgment of relevant information, thus reducing the mental effort required to make financial decisions. In the absence of such categorization, we would need to assess our full financial portfolio when faced with nearly any consumption decision (Zhang & Sussman, 2018). The budgeting process also helps us make rational allocate funds between competing needs and uses (Thaler,1999).
Second, the budgeting system acts as a self-control device by pre-committing our spending towards our long terms goals, thereby helping us to resist the temptation of immediate consumption opportunities. Also, transaction specific accounts help make sure that when we pay for something in advance, we end up consuming it and not wasting it in favor of another consumption opportunity (Cheema & Soman, 2006).
And finally, based on the situation, bracketing financial outcomes together or separately can help us minimize pain of losses. E.g. if we have no option but to bear multiple losses of similar nature, we prefer to experience them close together in time, so we can group them into the same bracket and treat them as a single loss, thus minimizing the mental displeasure. Credit cards use this tendency by facilitating a single integrated bill payment for all our purchases rather than paying for each purchase directly from our bank account. But if the losses are not similar and cannot be bracketed together, we prefer to spread them apart in time to spread out the displeasure. In contrast, we prefer to spread similar gains across time to multiply the pleasure, and group dissimilar gains close together so that we can still treat them independently and derive more pleasure (Evers et al., 2021).
When an expense doesn't perfectly fit into any of the existing mental accounts, we may misuse the flexibility by putting the expense in an account that allows us to cheat on our own spending goals (Cheema & Soman, 2006). Similarly, we may decide that small or infrequent expenses do not need to be accounted for. For example, that $5 monthly fee you pay on that app which you barely use, but who cares for such a small amount. This kind of omission and flexibility can lead to overspending (Zhang & Sussman, 2018).
Now, inflexible budgets can also can be counterproductive because they can prevent us from reallocating funds to other budgets(Thaler,1999). E.g. our transportation budget on a trip may be spent up to its limit and fall short, while food budget may have unspent funds remaining. As a result, we could end up taking an uncomfortable and time-consuming transport option, instead of using the extra money from food budget.
Next, narrow bracketing of choices, e.g. on a daily basis rather than monthly or weekly basis, can lead to myopic decisions where we miss opportunities for long term gains in pursuit of immediate gains (Thaler,1999). For example, say a cab driver has a daily earning goal after which he stops driving. On busy days, he'll earn quicker and get done quite early. But if he stays out longer on busy day, he might earn enough to take much more time off on regular days. So a weekly or monthly earning goal might be a better strategy than daily goals for this driver.
Next, due to the pain of payment, we feel compelled to consume things we have already paid for, even if the experience is not pleasurable (Soster et al., 2010). For example, if we order too much food, we feel compelled to finish it even though overeating may cause discomfort. Indeed, we often prefer to pay in advance to avoid the pain of paying during consumption. E.g. We may pay for annual gym membership so that we don't experience the pain of paying every time we use the gym. But this may lead to overspending, if our usage is not proportional to the prepayment.
And lastly, categorizing funds can constrain our choice set because we often end up spending funds based on where they come from. So when we receive gift cards, we tend to use them on luxury or indulgent items, even if the same funds may be more productively used on regular items (Reinholtz et al., 2015; Helion & Gilovich, 2014).
And finally, let’s look at some strategies to manage the undesirable aspects of impact and to use it to our advantage.
First, if consumption calls to mind thoughts of payment, the pain of payment is likely to limit consumption. This can be used as a self-control device. On the flipside, if we want to increase consumption, we should use measures that dissociate payment from consumption. Some financing methods, such as credit cards, weaken the coupling of payments and consumption, whereas others, such as cash payment, produce tight coupling. Flat-rate pricing schemes such as unlimited Internet access at a fixed monthly price, also weaken coupling and are often preferred by consumers even if it involves paying more for the same usage (Prelec & Loewenstein, 1998).
Next, while evaluating the affordability of goods, we compare the cost with the amount of resources available for the purchase. But to estimate resources available, we consider cognitively accessible accounts rather than our total wealth (Morewedge et al., 2007). So, a $50 purchase will seem more affordable if we have $1000 in our wallet than if we have $500 in the wallet. Having credit and debit cards increase the amount of resources that are accessible, therefore making purchases seem more affordable.
Next, we tend to have a hierarchy of mental accounts in terms of how tempting it is to spend money in each. E.g. food or transport budget is more likely to be spent for other uses compared to health or emergency funds. Long term-saving and investment accounts tend to be off-limits. Funds that are transferred to less tempting mental accounts are more likely to be saved (Karlsson et al., 1997; Thaler,1999).
Next, narrow bracketing leads to less willingness to take risks, because we evaluate the deviations from our goals and expectation even for smaller choices and outcomes. This fear of a loss helps us stick to our goals. So it is good for self control but not for long-term planning wherein accepting some risk is beneficial. E.g. a business takes time to become profitable, but a businessman who is not willing to accept some initial losses will not be able to pursue long term opportunities. On the other hand, with broad bracketing, falling short of our goal in one outcome can be balanced out by exceeding our goal in another outcome, so we are willing to take more risks, but we are also less motivated towards our goals because we feel insured against losses. So depending on whether we want to take risks or exercise self control, we cand decide to bracket narrowly or broadly (Koch & Nafziger, 2016).
And finally, the tendency to categorize is associated with analytical thinking style. Holistic thinkers display more flexible mental accounting. Studies have shown that holistic thinking results in a more comprehensive accounting process, and avoids a lot of the undesirable impacts of mental accounting on our decision-making (Banerjee et al, 2019; Hossain, 2018).
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