The compartments of your (financial) mind

We are all mental accountants, for better and for worse

You probably have them too in your purse or your wallet: a stack of store loyalty cards. Every time you pass a till, you habitually hand over a piece of plastic, and as if by magic points — it’s always points — get added to your account. And then you get some vouchers to use next time, giving you extra points when you buy deodorant, breakfast cereal or canned plum tomatoes.

What you surely know, but dont necessarily realize all the time, is that a point represents real money. Not much money, though. One point, at the supermarket where we get our groceries, is worth half a penny. There isn’t even a 0.5p coin any more — it was taken out of circulation at the end of 1984. But the points do add up, eventually.

They can generally be exchanged for a cash discount at the till, something a rational person would of course do at every occasion. Why leave them in what is effectively a 0% interest savings account? The best thing to do would be to keep your points balance as close as possible to zero, and reduce the shopping bill every shopping trip. But do I do so? Nope. And I am not alone: according to a Daily Telegraph article, in 2015 20% of loyalty scheme members had not cashed in any points in the preceding year, and 7% had never redeemed them.

I am a very loyal person (image: Gordon Joly)

One possible explanation is the so-called euro effect. In her PhD dissertation, Amelie Gamble, a psychologist at the university of Göteborg, describes how our perception of actual value is influenced by the nominal value of a currency. If they have a higher nominal value (like the points) than the one we’re familiar with (like pounds) they tend to be seen as worth more. That means accumulating points feels more attractive than spending them: the 200 points you add to your account feel more valuable than the £1 reduction to your bill they would give you.

It’s also an example of what the Economics Nobel winner Richard Thaler has termed mental accounting. This is the practice of mentally dividing a resource like money into different categories. Strictly speaking, money is fungible: there is no difference between one pound coin and another one, or indeed between £1 and something else that is worth exactly £1 (such as 200 points). But that is not the way we look at things. Points are points, and money is money. At best, the points can be ‘supermarket money’. But we will not normally feel they can pay for, say, a family meal, even though we could easily use them to pay for our shopping, and then use the money we thus did not have to spend to pay the restaurant.

In an interview for American National Public Radio, Thaler gives a striking example of mental accounting, referring to this video:

When they were both young and impecunious actors, Gene Hackman goes to visit Dustin Hoffman. Hoffman asks Hackman whether he can lend him some money. But in the kitchen, Hackman spots a range of jars, each with a label — rent, entertainment, books and so on. All contain some money, except the one labelled ‘food’. So he says, “You don’t need to borrow money — you’ve got money!” upon which Hoffman replies that he can’t take the money out of the other jars to pay for food.

Hoffman’s version of mental accounting may be quirky and amusing. But unlike the variant that leaves tens or hundreds of pounds in an account that doesn’t produce any return to us, it is actually not a bad idea, especially if you’re strapped for cash. It makes your trade-offs very visible. It helps you protect the money for the rent, and hence safeguard the roof over your head, and it challenges you to justify that you value entertainment more than food on the table.

Money in the jar

But mental accounting can also confuse and fool us, especially if others are doing the ‘mentalizing’. When we buy something online, we operate separate mental compartments for ‘stuff’ and for ‘shipping’, and sellers can play with this. If they have a low price for the ‘stuff’ then they can hook and reel us in, while we’re ignoring the ‘shipping’ compartment. Only some weirdo (don’t all look at me!) would scan every supplier’s offer, put prices and shipping charges in a spreadsheet, and work out the total cost for each one to find the cheapest overall. Then again, some sellers include shipping in the selling price. That makes comparison easy, and if they call it ‘free’ shipping, they might have the edge on those who still split it off. Zero cost in one of the compartments is very appealing.

Amazon is very good at using this ploy. With a low threshold to be entitled to free shipping (just $25, £20 or €29), the lure is often so great that we happily add another item to our order simply to get it delivered free of charge. And with Prime, the shipping cost becomes an entirely separate sunk cost we pay once a year as our subscription — which further entices us to buy ‘stuff’, and enjoy our free lunch while we fill Amazon’s coffers.

Is receiving a tax refund a good thing? Intuitively it sounds great: the mental jar labelled ‘tax’ is one to put money in, not one you can take money out. Finding extra money in it obviously brings a big grin to your face. Until you realize you’re fooling yourself: that money was yours all along. The tax man is simply giving you back what you overpaid earlier.

But such trickery can actually benefit you. Last week, Moneyweek published a small article (it’s halfway down the page when you click) praising a change by the Nationwide, the world’s largest building society, to its retirement savings scheme. Before, employees contributed 4% of their salary (to which the employer added a further 9%), which they could increase to 7% (matched by the company). After the change, the maximum of 7% became the default, which employees could reduce back to 4% if they so wished. This turned out to be a very successful nudge using the status quo bias to encourage people to save more: while at first only 9% of employees made the maximum contribution, today a whopping 84% are doing so.

The real smoke and mirrors, however, are in the so-called “employer’s” contributions. Free money! Does that money really come from the employer? Well, yes, but so does the salary. The employer simply chooses to divide the total amount it pays an employee into two mental accounts: one in a jar labelled ‘wages’, and one in a jar labelled ‘pension contribution’. The free money is really an illusion, but more than the change in the default contribution, it is this illusion that is the allure of a retirement savings scheme.

Like so many psychological concepts, mental accounting is a two edged sword. Where does it help you, and where does it fool you? Just a little bit of mental effort will tell…

Originally published at on December 1, 2017.

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Accidental behavioural economist in search of wisdom. Uses insights from (behavioural) economics in organization development. On Twitter as @koenfucius

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