NOT ALL DOLLARS ARE CREATED EQUAL
By the third day of their honeymoon in Las Vegas, the newlyweds had lost their $1,000 gambling allowance. That night in bed, the groom noticed a glowing object on the dresser. Upon closer inspection, he realized it was a $5 chip they had saved as a souvenir. Strangely, the number 17 was flashing on the chip's face. Taking this as an omen, he donned his green bathrobe and rushed down to the roulette tables, where he placed the $5 chip on the square marked 17. Sure enough, the ball hit 17 and the 35-1 bet paid $175. He let his winnings ride, and once again the little ball landed on 17, paying $6,125. And so it went, until the lucky groom was about to wager $7.5 million. Unfortunately the floor manager intervened, claiming that the casino didn't have the money to pay should 17 hit again. Undaunted, the groom taxied to a better-financed casino downtown. Once again he bet it all on 17 and once again it hit, paying more than $262 million. Ecstatic, he let his millions ride only to lose it all when the ball fell on 18. Broke and dejected, the groom walked the several miles back to his hotel.
"Where were you?" asked his bride as he entered their room.
"How did you do?"
"Not bad. I lost five dollars."
This story told in some parts of Nevada as the gospel truth has the distinction of being the only roulette joke we know that deals with a bedrock principle of behavioral economics. Indeed, depending on whether or not you agree with our groom's accounting of his evening's adventure, you might have an inkling as to why we considered a different title for this chapter, something like "Why Casinos Always Make Money." The conventional answer to that question that casinos are consistently profitable because the odds for every game are stacked in favor of management does not tell the whole story. Another reason casinos always make money is that too many people think like our newlywed: because he started his evening with just $5, he felt his loss was limited to that amount.
This view holds that his gambling spree winnings were somehow not real money or not his money, in any event and so his losses were not real losses. No matter that had the groom left the casino after his penultimate bet, he could have walked across the street and bought a brand-new Rolls-Royce for every behavioral economist in the country and had enough left over to remain a multimillionaire. The happy salesman at the twenty-four-hour dealership this is a Vegas story, after all would never have thought to ask if the $262 million actually belonged to the groom. Of course it did. But the groom never really saw it that way. Like millions of amateur gamblers, he viewed his winnings as an entirely different kind of money and was therefore more willing to make extravagant bets with it. In casino-speak this is called playing with "house money." The tendency of most gamblers to fall prey to this illusion is why casinos would likely make out like bandits even if the odds were stacked less heavily in their favor.
The "Legend of the Man in the Green Bathrobe" as the above tale is known illustrates a concept that behavioral economists call "mental accounting." This idea, developed and championed by the University of Chicago's Richard Thaler, underlies one of the most common and costly money mistakes the tendency to value some dollars less than others and thus to waste them. More formally, mental accounting refers to the inclination to categorize and treat money differently depending on where it comes from, where it is kept, or how it is spent. To understand how natural, and tricky, this habit can be, consider the following pair of scenarios. Here, as in similar mental exercises you'll find sprinkled throughout this book, try as best as you can to answer each question as realistically as possible. The more "honest" your responses, the more you'll learn about yourself.
Imagine that you've bought a ticket to the Super Bowl or a hit Broadway play. At the stadium or theater you realize you've lost your ticket, which cost $150. Do you spend another $150 to see the game or performance?
Now imagine the same scenario, but you're planning to buy the $150 ticket when you arrive. At the box office, you realize you've lost $150 somewhere in the parking lot. Still, you have more than enough in your wallet to buy the ticket. Do you?
If you're like most people, you probably answered "no" to the first question and "yes" to the second, even though both scenarios present the same dilemma: a loss of $150 and the subsequent prospect of spending another $150 to be entertained. The reason for this seeming inconsistency is that for most people the first scenario somehow translates into a total entertainment cost of $300 two actual tickets, each costing $150. This might be too much, even for a Super Bowl or hit play. Conversely, for most people the loss of $150 in cash and the $150 cost of the ticket are somehow separated mentally into two independent categories or accounts. They are unfortunate but unrelated. This type of thinking treating two essentially equal $150 losses in very different ways because they occur in different manners is a classic example of mental accounting.
The notion of mental accounts is anathema to traditional economics, which holds that wealth in general, and money in particular, should be "fungible." Fungibility, at its essence, means that $100 in roulette winnings, $100 in salary, and a $100 tax refund should have the same significance and value to you, since each Benjamin (as the kids like to say) could buy the same number of Happy Meals at McDonald's. Likewise, $100 kept under the mattress should invoke the same feelings or sense of wealth as $100 in a bank account or $100 in U.S. Treasury securities (ignoring the fact that money in the bank, or in T-bills, is safer than cash under the bed). If money and wealth are fungible, there should be no difference in the way we spend gambling winnings or salary. Every financial decision should result from a rational calculation of its effect on our overall wealth.
If only this were the case. In reality, as you probably have noticed, people are not computers. They lack the computational power and the strength of will necessary to manage all their finances on a consolidated balance sheet. It would be intellectually difficult, and emotionally taxing, to calculate the cost of every short-term transaction (buying a new compact disc, for instance, or going to a movie) against the size of every long-term goal or need (planning for retirement or saving for college). So to cope with this daunting organizational task, people separate their money into mental accounts, necessarily treating a dollar in one account differently from a dollar in another, since each account has a different significance. A vacation allowance, for instance, is presumably treated with less gravitas than the same amount of money socked away in an Individual Retirement Account.
But what's wrong with that? The average person, more self-aware, perhaps, than the average economist, knows that he or she is not as smart or as iron willed as economists maintain. And that's why people set up mental accounts in the first place. Thus, rather than being illogical or irrational, the ability to corral money into different mental accounts often has beneficial effects. Most important, perhaps, it allows you to save effectively for future goals. After all, "house money" for many Americans is not casino winnings, but the money they manage to squirrel away for a down payment on their dream home. Even profligate spenders manage to avoid tapping into these savings, often for no other reason than that they've placed it in a sacred mental vault. Certainly mental accounting is not always effective, given the problems human beings have with self-control. That's one of the reasons certain tax-deferred retirement accounts such as IRAs or Keogh plans penalize early withdrawals, and it is why they enjoy such popular support. And that is why, when attempting to balance and evaluate their investment portfolio, people often err by failing to knock down mental walls among accounts. As a result, their true portfolio mix the combination of stocks, bonds, real estate, mutual funds, and the like is often not what they think, and their investment performance often suffers.
In any event, the sometimes useful habit of treating one dollar differently from another has a dark side as well, with consequences far more significant than simply increasing your willingness to make risky bets at roulette tables. 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. We'll get to all of that shortly, but the easiest-to-explain instance of mental accounting's harmful effects is the different value people place on earned income as opposed to gift income. That is, we'll spend $50 from Mom (or $50 we find in the street) with less thought than $50 we've earned on the job. Still, while such distinctions may be illogical from a strict economic point of view, they seem reasonable and harmless enough. After all, gift money or casino winnings, for that matter is generally "found" money. You didn't have it one second before you got it, so what's the harm in not having it again?
True enough. More troubling, though, and potentially more costly, is the tendency people have to "deposit" money in certain mental accounts when that money is actually part of another. Consider tax refunds, for example. Many people categorize 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 money market mutual fund, they would most likely think long and hard before spending it on a new suit or Jacuzzi. However, because the "bank account" in which those funds have been sitting is run by Uncle Sam, taxpayers' mental accounting systems attach a different value to those dollars.
A DOLLAR HERE, A DOLLAR THERE PRETTY SOON WE'RE TALKING ABOUT REAL MONEY
Another way mental accounting can cause trouble is the resultant tendency to treat dollars differently depending on the size of the particular mental account in which they are stashed, the size of the particular transaction in which they are spent, or simply the amount of money in question. Here's an illustration of what we mean:
Imagine that you go to a store to buy a lamp, which sells for $100. At the store you discover that the same lamp is on sale for $75 at a branch of the store five blocks away. Do you go to the other branch to get the lower price?
Now imagine that you go to the same store to buy a dining room set, which sells for $1,775. At the store you discover that you can buy the same table and chairs for $1,750 at a branch of the store five blocks away. Do you go to the other branch to get the lower price?
Once again, studies tell us that more people will go to the other branch to save on the lamp than would travel the same distance to save on the dining room set, even though both scenarios offer the same essential choice: Would you walk five blocks to save $25? You probably don't need to think long or hard to come up with instances in which this tendency can become quite costly (for you, that is it's generally quite profitable for some salesperson). We certainly don't. As a struggling college student in the early 1980s, Gary had decided against replacing his car radio with a new cassette deck, for the simple reason that he couldn't justify the $300-$400 it would cost to buy the new piece of equipment. In his last year of college, though, Gary finally bought a new car (with the aid of a hefty auto loan). The cost: $12,000 plus another $550 for a cassette deck to replace the optional AM/FM radio. Three months earlier before his car broke down Gary had shopped for cassette decks and deemed $300 too extravagant. Yet a car salesman had little trouble convincing him to spend almost twice that amount for the same product, even though Gary's finances were presumably more precarious now that he had to make $180 monthly payments for the next four years.
The main culprit, of course, was mental accounting $550 seemed to have less value next to $12,000. But also contributing to Gary's decision was the subconscious preference, shared by most people, to "integrate losses." Translation: When you incur a loss or expense, you prefer to hide it from yourself by burying it within a bigger loss or expense, so that the pain of spending $550 for a cassette deck was neutralized to a great extent by the larger pain of spending twelve grand.
Businesses, by the way, understand this tendency only too well. 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 it's why insurance agents sell exotic "riders" at the same time they're pushing broader policies. Would any rational person buy life insurance for, say, their young children if the policy was offered to them separately?
Mental accounting helps to explain one of the great puzzles of personal finance why people who don't see themselves as reckless spenders can't seem to save enough. The devil, as they say, is in the details. Although many people are cost-conscious when making large financial decisions such as buying a house, car, or appliance mental accounting makes them relax their discipline when making small purchases. The cost of such purchases gets lost among larger expenses, such as the week's grocery bill, or charged against a lightly monitored "slush fund" account. The problem, of course, is that while you might purchase a car or refrigerator every few years, you buy groceries and clothes and movie refreshments every week or every day. Being cost-conscious when making little purchases is where you can often rack up big savings.
The principles of mental accounting are governed not only by the size of a purchase or investment, but also by the size of a payment received, be it a bonus, rebate, refund, or gift. Thus, a payment that might otherwise be placed in a discretionary mental account a bonus at work, say, or a tax refund will be deposited in a more serious, long-term account if it is big enough (and vice versa). That's curious, when you think about it. If you get a fairly small refund or bonus let's say $250 chances are you're far more likely to buy a $250 pair of shoes with it than if you get a $2,500 bonus or refund, even though you can presumably afford it more in the second instance. Somehow, a bigger chunk of found money makes it more sacred and serious and harder to spend, actually lowering your "spending rate" (or what economists call the "marginal propensity to consume"). Understanding this concept can help you understand why it may be difficult for you to hold on to money and why a bonus or a gift may actually do you more harm than good. (Don't worry, though our advice won't be to stop accepting gifts.) Your spending rate is simply the percentage of an incremental dollar that you spend rather than save. So if you receive a $100 tax refund and spend $80, your spending rate is .80 (or 80 percent). You might think, therefore, that the highest spending rate you can have is 1 that is, for every incremental dollar you receive, the most you could spend is a dollar. Alas, you'd be wrong. Let us explain.
About thirty years ago, an economist at the Bank of Israel named Michael Landsberger undertook a study of a group of Israelis who were receiving regular restitution payments from the West German government after World War II. Although these payments could without exaggeration be described as blood money inasmuch as they were intended to make up for Nazi atrocities they could also fairly accurately be described as found money. Because of this, and because the payments varied significantly in size from one individual or family to another, Landsberger was able to gauge the effect of the size of such windfalls on each recipient's spending rate. What he discovered was amazing. The group of recipients who received the larger payments (which were equal to about two-thirds of their annual income) had a spending rate of about 0.23. In other words, for every dollar they received, their marginal spending increased by 23 percent; the rest was saved. Conversely, the group that received the smallest windfall payments (equal to about 7 percent of annual income) had a spending rate of 2. That's correct: for every dollar of found money, they spent two. Or, more accurately, for every dollar of found money, they spent $1 of found money and another $1 from "savings" (what they actually saved or what they might have saved).
Obviously we can't explain this curious phenomenon with certainty. Perhaps restitution payments were made in proportion to a family's earlier earnings in Europe. If so, it may be that people who earned a lot before the war were also earning a lot in Israel and therefore had less pent-up "need" to spend their restitution checks. In Israel, like everywhere else, the wealthy save a higher proportion of their income than the poor. But this cannot explain why the spending rate of those receiving the smallest restitution payments was a whopping 200 percent. The poor are not helped by spending twice as much as they receive. A clearer understanding of this phenomenon may be obtained by considering the recent experience of a friend. This friend, let's call him Peter, works overseas for a small U.S. company. While on vacation in America, he stopped by corporate headquarters to say "hi" and, to his surprise, received a $400 bonus. Lucky, eh? Well, maybe not. By the end of his trip, Peter realized he had spent that $400 about five times over. It seems that every time he went into a store or restaurant, Peter and his wife used that $400 bonus to justify all manner of purchases. Not only was that bonus mentally accounted for as found money suitable for discretionary spending, it also sucked in $1,600 of the couple's money that had been accounted for otherwise.
Americanesia Expressaphobia, n 1. Financial affliction, first diagnosed in late twentieth century, in which the sufferer forgets the amount charged on a credit card but is terribly afraid that it's way too much. Closely related to Visago, n, in which a high level of debt prompts feeling of nausea and dizziness.
There's one more thing we ought to tell you about Peter's vacation saga, not least because we in no way want to discourage any bosses who might be reading this book from continuing to hand out bonuses, large or small. Much of Peter's shopping spree was abetted by credit cards, one of the scariest exhibits in the museum of mental accounting. In fact, credit cards and other types of revolving loans are almost by definition mental accounts, and dangerous ones at that. Credit card dollars are cheapened because there is seemingly no loss at the moment of purchase, at least on a visceral level. Think of it this way: If you have $100 cash in your pocket and you pay $50 for a toaster, you experience the purchase as cutting your pocket money in half. If you charge that toaster, though, you don't experience the same loss of buying power that emptying your wallet of $50 brings. In fact, the money we charge on plastic is devalued because it seems as if we're not actually spending anything when we use the cards. Sort of like Monopoly money. The irony, of course, is that the dollar we charge on plastic is actually more valuable, inasmuch as it costs an additional sixteen cents to spend it 16 percent or so being the typical interest rate for such borrowing.
Irony aside, we're not likely to surprise many readers by pointing out that credit cards play directly into the tendency to treat dollars differently. Because they seem to devalue dollars, credit cards cause you to spend money that you might not ordinarily spend. So common is credit card use and abuse today at this writing the average U.S. consumer with revolving loans has more than $7,000 in credit card debt that you've probably suffered a bout or two of Americanesia Expressaphobia yourself. No revelation there. But you may be surprised to learn that by using credit cards, you not only increase your chances of spending to begin with, you also increase the likelihood that you will pay more when you spend than you would if you were paying cash (or paying by check).
Want proof? Consider an experiment conducted several years ago by Drazen Prelec and Duncan Simester, marketing professors at the Massachusetts Institute of Technology in Cambridge, Massachusetts. The pair organized a real-life, sealed-bid auction for tickets to a Boston Celtics game (this was during the Larry Bird, Kevin McHale, Robert Parish era, so the tickets were especially valuable). Half the participants in the auction were informed that whoever won the bidding would have to pay for the tickets in cash (although they had a day to come up with the funds). The other half were told that the winning bidder would have to pay by credit card. Prelec and Simester then averaged the bids of those who thought they would have to pay in cash and those who thought they could pay with a credit card. Incredibly, the average credit card bid was roughly twice as large as the average cash bid. Simply because they were dealing with plastic with money that was devalued in some way the students became spendthrifts. Put another way, credit cards turn us into big spenders in more ways than one. We become poorer because we're more likely to spend, and more likely to spend poorly.
IT'S NOT GRANDMA'S MONEY
One final thought about mental accounting (at least for now). We've noted that the tendency to categorize, segregate, or label money differently can have the side effect of causing people to be more reckless with their money. Dollars assigned to some mental accounts are devalued, which leads us to spend more easily and more foolishly, particularly when dealing with small (though not inconsequential) amounts of money. But there's a flip side to this coin that can have the opposite effect the tendency to mentally account for money as so sacred or special that we actually become too conservative with it.
The best way to demonstrate this phenomenon is with a story about a woman in her thirties named Sara. Sara is actually a fairly sophisticated investor, with a well-diversified portfolio of stocks and stock mutual funds. Good for her, considering that stocks have offered the best average annual return of all the major savings and investment categories over the past seventy years about 11 percent a year on average, vs. 5 percent a year for bonds and 3 percent for cash in the bank. Several years ago, however, Sara inherited about $17,000 from her grandmother. Although she didn't need the money for any particular short-term or long-term goal, Sara parked her grandmother's inheritance in a bank account paying about 3 percent a year in interest. Her grandmother, whom Sara adored, had worked and saved all her life to scrape together the money that she eventually left to Sara and her four siblings. As a result, Sara was hesitant to put her grandmother's money at risk in the stock market, not least because Sara was raised by parents whose memory of the Great Depression and the stock market crash of 1929 made them and their daughter overly fearful about the risks of stocks. In any event, it didn't seem right to Sara, who would have been far more crushed if she lost "Grandma's money" than if she lost her own.
Her hesitation was costly. If Sara had simply invested that money as she does her other savings in mutual funds that roughly approximated the overall performance of the stock market she would now have more than $37,000. Instead, earning a meager 3 percent, she has just $18,600. Now it would be one thing if Sara had decided that she needed her grandmother's money for a specific short-term goal such as a down payment on a house, which would justify avoiding the stock market for fear of needing the money at just the time when stock prices were experiencing one of their inevitable dips. But Sara had no such constraint. Although other factors may cause people to be overly conservative with their investments, Sara's mistake was to mentally account for the $17,000 as "Grandma's money," or at least as money that was more sacred than her own savings and thus money that shouldn't be risked. In reality, of course, the money was hers, and the cost of her mental accounting was about $19,000.
Sara's mistake, we should add, is replicated by millions of Americans who choose the most conservative investment options in their 401(k), 403(b), and 457 plans at work because they mentally account for those funds as too sacred. This kind of thinking "I have to be careful with my retirement money" exposes you to a far more dangerous risk than the short-term ups and downs of the stock market: you run the risk that you won't have saved enough when your retirement finally rolls around.
HOW TO THINK AND WHAT TO DO
You may be prone to mental accounting if...
* you don't think you're a reckless spender, but you have trouble saving.
* you have savings in the bank and revolving balances on your credit cards.
* you're more likely to splurge with a tax refund than with savings.
* you seem to spend more when you use credit cards than when you use cash.
* most of your retirement savings are in fixed-income or other conservative investments.
How's this for practical advice about mental accounting: Stop it! If you charge too much on credit cards, cut'em up. If you blow tax refunds at the track, cut it out. If only it were that easy. The difficulty with trying to remedy your tendency toward mental accounting is that you don't want to throw out the baby with the binge borrowing. For people who generally can't seem to control spending, mental accounts can often be the most effective way to ensure that the mortgage gets paid, the kids' colleges get funded, or there is enough money to live comfortably in retirement. And, of course, for every Sara who is too conservative with windfall money, there is someone else who would mentally account for an inheritance as gift money and blow it impulsively on a new stereo system. In fact, those two people may be one and the same Sara may put inheritance money in one mental account, while stashing a tax refund or gambling winnings in another.
So in order to begin to eliminate the harmful elements of mental accounting, while preserving its benefits, you have to audit your own internal accounting system. We'll give you two ways to begin this process, one that's fun and one that's a bit more serious. First the fun stuff, in the form of another set of scenarios.
Imagine that you're at the racetrack for a day of gambling or at your favorite store shopping for a suit. Yesterday you won $1,000 from your state's instant lottery game. Will you bet more tonight than you would otherwise, or will you buy a more expensive suit?
Now imagine that you're once again at the racetrack for a day of gambling or at your favorite store shopping for a suit. Yesterday you realized that you had $1,000 in a savings account that you had forgotten about. Will you bet more tonight than you would otherwise, or will you buy a more expensive suit?
If you answered "yes" to the first question and "no" to the second as most people would you're prone to mental accounting, which means you're prone to wasting money because you wrongly put different values on the same dollars. No doubt skeptics will say that it is perfectly logical to be more reckless with lottery winnings than rediscovered savings, so what is Belsky and Gilovich's problem? Our problem is that while it may not make a difference if you blow a Lotto payoff, this habit can cost you money in ways you might not even think about. Our second test should help doubters see the light.
All you need to do is review your finances and answer two questions: 1) Do you have emergency or other nonretirement savings?; and 2) Do you carry balances on your credit cards from month to month?
If the answer is "yes" to both, you're a victim of mental accounting. Why? Because you've placed an inappropriately high value on your savings dollar and too low a value on your borrowed dollars. As a result, you're likely earning 5 percent a year on your emergency savings, while paying 16 percent a year in credit card interest. For every $1,000 on your credit card, that's a yearly loss of roughly $110. If you do nothing else after reading this but pay off $1,000 in credit card balances with short-term savings, then you've earned the price of this book about five times over. And for those people who say that emergency money should be left just for emergencies, our response is that if you pay off your credit card balances with short-term savings, you could always fill up those same credit cards in the event that you or your spouse is laid off or laid up. Believe us when we tell you that your credit card company won't cut or eliminate your access to their high-rate loans if you pay off your balances. More than likely they'll raise your credit limit, so that you'll be that much more prepared for "emergencies." And all the while you'll be saving the difference between the money you would have been paying in interest and the money you would have earned from a money market account.
Imagine a world without plastic. No, we're not suggesting you deep-six your Visa or Sears card. We're just recommending that you start asking yourself how much you would pay for a prospective purchase if you were paying cash out of your pocket. You might answer that you would pay a lot less than you're willing to charge or even that you wouldn't make the purchase at all.
See the trees for the forest. That's another way of saying that when you make a big purchase or investment such as a car or a house break every deal into its component part. Would you, say, pay $3,000 to put a skylight into the den of your current house? If not, then don't tack on that extra when contracting for a new home $3,000 may not seem like a lot when you're buying a $150,000 home, but it buys just as much as $3,000 in your checking account (more, actually, when you count the interest you'll pay over the course of your loan).
Hurry up and wait. To the extent that you fall prey to the tendency to view windfall money tax refunds, gifts, inheritances, or bonuses as found money that can be spent relatively carelessly, our advice is to train yourself to wait a while before making any spending decisions. In other words, tell yourself that you can do whatever you want with that cash, but in three or six months. In the meantime, park it in a bank or money market account. Make that the rule. At the least you'll have a few extra dollars for your trouble. More than likely, by the time your deadline rolls around you'll view this money as savings hard earned and not to be wasted.
Imagine that all income is earned income. This idea for dealing with money that you didn't earn or even money for which you did work may be the best way to train yourself to view all your money equally. Basically, the trick is to ask yourself how long it would take you to earn that amount of money after taxes. Quite often the answer will clear up your accounting problems faster than you can say "marginal tax rate."
Use mental accounting to your advantage. This kernel of counsel is essentially an endorsement for payroll deduction plans. Folks who have difficulty holding on to small amounts of money often have difficulty saving, for the obvious reason that small amounts are what are left in our paychecks after we pay the bills. That's where labeling tricks can help. By funneling money into a mutual fund or savings account directly from your paycheck, $50 that you might have accounted for as bowling money and spent easily is mentally (and physically) accounted for as savings and thus less likely to be wasted and more likely to be around when you need it.
There is another reason that payroll deduction plans are a good idea, one that involves an important psychological principle we discuss in the next chapter. Psychologically it's much easier to part with your money to set it aside this way than by writing a check to your savings account. Let us explain why.
Copyright © 1999 by Gary Belsky and Thomas Gilovich