A behavioral economics thought experiment:
A man spends $150 on two tickets to the local opera, only to arrive to the theatre and find that he has lost his tickets. Will he spend another $150 on new tickets?
A variation: The same man brings $150 in cash to the theater with the intention of spending that cash on two opera tickets, only to discover that the cash is missing. Does he use his credit card to purchase tickets instead?
Most would respond to the first scenario, assuming that he would not want to spend an additional $150 for the tickets after losing his first set. However, many people believe the man would probably go ahead and use his credit card to purchase the opera tickets after losing his money to pay for them originally.
In both of these scenarios the man will be out of an extra $150, so why are there two different reactions. It has something to do with how the way you categorize your budget in your mind affects your in-the-moment spending.
The Balance Sheet in Your Brain
In Claudia Hammond’s book Mind Over Money, she dives into the economic theory of “mental accounts” as identified by Richard Thaler in his scholarly article, Mental Money Matters.
Essentially, the reason some spenders feel like it’s okay to purchase those tickets with the credit card in leiu of the lost cash is because we sort our purchases into mental categories, not the money itself. We think of our purchases holistically, viewing expenses that are relative to one another in the same category.
Because the man already planned to spend a certain amount of money on this certain category, even though money was lost, he still plans to spend that amount of money on this category. In the first scenario, the man had already spent the money on that category, causing him to have apprehensions on spending an additional $150 in the same category. It would feel like he was exceeding his budget for that particular mental account.
In other words, it’s all the same money, but how we perceive certain expenses changes drastically depending on how we mentally categorize them.
Make Your Categories Work For You
While mental accounting is a great strategy over all, there are pitfalls that savvy spenders should avoid. Only relying on the mental accounts can distort what our perception of value and sound spending can mean. Even separating meals at home and meals out can lead to poor purchasing decisions.
For example, you may perceive that buying your meals away from home at a higher value in your food category because it’s an experience. But really, it’s essentially more money for less substance. You can save so much more money by taking your meals at home.
Another example is holiday spending. You’ve probably already created a temporary mental account for the holidays. You’ll likely budget close to what your spending was last year, instead of gauging it on what you’ve been spending since the last holiday season. This can lead to making decisions that seem reasonable at the time, but may not fit your current situation.
The key to mastering this concept is by narrowing your mental accounts down and broadening the way you compare expenses. Thinking back to our example in the introduction, it should really matter how the man loses out on $150, because at the end of the day, the money is still lost. The question isn’t how he lost it. It should be whether he has the spare $150 to cover the extra cost. It’s important to take a moment to be honest about your financial situation in these moments to make a clear decision on whether to make the extra purchase or not.
Ultimately, just be aware of your spending and even more aware of the reasons you are spending. Every HomeTown Bank checking account comes with a Personal Finance Management tool that can help your wrangle in these categories and keep track of where your money is going.