What is the Mental accounting bias?
Mental accounting bias is when people form emotional attachment with money in different categories. They see the money in different ways depending on where they feel it belongs.
The people can’t transfer money from one category to another, so they will be emotionally upset if something bad happens during that mental transaction – like selling their only stock because of too much risk exposure or buying things that they don’t need just because it is on discount.
For example: A customer wants to buy an expensive item and his credit card has $300 limit. He uses his credit card to cover all of the cost; therefore, he is mentally accounting this purchase towards his credit card spending limit instead of thinking of it as a debt for which he will have to pay in the future.
Why this bias is dangerous?
People can’t easily move money from one mental account to another, so when they have a small amount of money in their savings account and they need to buy something expensive, they might see it as a problem that sets them back in the whole financial plan. This will lead to borrowing money or not buying anything at all which makes people suffer in the long term because of choice paralysis .
If you make too many mental transactions you spend more time thinking about your finances instead of enjoying life which leads to financial procrastination because once you start doing something, it’s hard to stop until there is an outcome. In this case, people want the outcome but don’t know how much work has to be put in.
Why do people use this bias?
People often think that money is real and it’s value will never change; however, they can’t imagine their future self because they don’t know how much resources (time, energy, health) will cost in the future -which means that people don’t like to save because of today’s pleasure principle . People also avoid taking losses which leads them to make mistakes with their investments by buying things they don’t need just because it looks good or creating personal projects that are worthless.
How do people use this bias?
Someone might buy an expensive house instead of investing his money by thinking that he needs shelter. This person is acting based on short-term emotions instead of thinking about his long-term security.
Another example is that people think they are saving money by borrowing money from credit cards for daily use or car loans because they see interest rates as penalties instead of seeing them as the cost of capital which will help them to be financially self-sufficient in the future.
How can we create this bias?
Change reference point: Show examples of how someone might feel if he loses something and then show him a different story – like losing $20 feels bad, but after doing some research you realize that it’s only 1% out of your weekly salary which makes you feel less upset . Another option would be showing a negative impact on a bigger scale -like losing $20 is 0.1% out of your yearly salary which makes you see it as a negligible loss .
Key takeaway: It’s not the value of an object but how much this value is worth to us that matters.
How to avoid this bias?
Instead of focusing on short-term losses, we should think about long-term gains. Instead of worrying about $500 college tuition, we should think of bigger picture and realize that after graduation we will be able to find better job with higher income and probably live in a nicer house. This will help us stop impulsive spending and focusing more on achieving our goals because we know losses will happen along the way, so we shouldn’t expect them all to go according to plan.
Form habits: Habits can affect our thoughts and feelings, but habits aren’t created instantly. We can choose to act outside of our « comfort zone » for at least 30-days in order to create a new habit that will change our thoughts about spending money.
Learn how to think differently: Change your point of view by reading books or listening podcasts about psychology, economics, law or business – these topics affect all areas of life including finances.
Mental accounting bias examples:
- Saving for something big:
You want to buy a new house but you can’t afford it because of student loans, credit cards and other expenses. You tell yourself that you’ll save money for half of the price or some percent like 20% in order to prepare for this goal. Next month your friend comes over and asks you to help him with moving so you borrow a truck from a family member so he won’t have to rent one -after all these movers will charge him $100 per hour . This situation makes you take out $200 from your savings account just because it’s only 2% ; therefore, if a bigger loss happens it won’t hurt that much or at least until retirement when losing this amount would be next to nothing.
- Take tax refunds:
Many people take their tax refund and spend it like it’s free money . They think that next year they will get the same amount or more, but this is wrong because getting a refund means you’ve overpaid; therefore, your account balance should be lower by this amount . People forget about compound interest which means that $1000 in savings can turn into $2000 after 10 years. The longer you save money, the more compound interest will increase your wealth over time so if someone starts saving at 30 instead of 20 – he’ll have twice as much valuable capital by retirement age.
Which profession use the bias?
Many salesmen will apply this bias in order to convince their clients that they need a product or service more than they actually do. For example, a salesman might say something like « you don’t have enough money for your kid’s education? Well you can pay it on installments and if you sign up now you’ll get 10% cash back! » Also, many financial advisers from banks or companies will use this bias aiming to sell expensive products with high fees – because even though the clients know how much it will cost them in the long run , some people forget about short-term losses so they decide to buy these products hoping that everything will go well while forgetting about market volatility.
Conclusion:
We shouldn’t avoid losses because they are natural part of life; instead we should accept change and learn how to deal with it because it’s inevitable . If you want to achieve something in the long run, you need take small losses here and there so if bigger ones happen you will be able to handle them without taking too much mental damage.