Most of us are familiar with what accounting is – but did you know our brains use the same processes? Investment adviser Sheryl Sutherland explains.
What is mental accounting?
‘Mental accounting’ sounds complex and a little off-putting. But it’s actually simple. Mental accounting refers to the way we think about our money and compartmentalise our financial activities. Our brain does the mental equivalent of our grandmother’s separate money tins that were earmarked for specific spending.
What are the three components of mental accounting?
1. How we perceive the results of spending and saving, and how we make and evaluate our decisions.
2. Like our grandmother’s money tins, we have specific ‘mental accounts’ that detail the use for our money: mortgage payments, retirement savings, or holiday savings.
3. The frequency with which we visit and evaluate the success or otherwise of our accounts, whether that’s weekly, daily, monthly or yearly.
How does it affect us?
Mental accounting is not neutral. It’s affected by our money psychology. We treat the dollars in our ‘mental accounts’ differently. Additionally, mental accounting is piecemeal in nature. We evaluate transactions one at a time rather than as a whole – this is why each of us would benefit from a coherent financial plan.
We identify gains and losses relative to an arbitrary reference point. Both gains and losses display diminishing sensitivity. For example, the difference between NZ$10 and NZ$20 seems bigger than the difference between NZ$1,000 and NZ$1,010. But NZ$10 is still NZ$10. The loss of NZ$100 hurts more than the pleasure of gaining NZ$100.
It might surprise you to know that this seems to be set in our psyches and doesn’t change.
It has been documented that 80 per cent of those who win Lotto, or come into an inheritance windfall have lost it all within a 10-year period.
Signs you’re doing mental accounting
· You make important spending decisions based on how much you’ve already spent.
· You tend to sell winning investments more readily than losing ones.
· You are seriously tempted to try to make money out of the share market when prices fall.
· You generally prefer term deposits over shares.
First published 7 November 2018
This article is part of the Rational Investor series by Sheryl Sutherland. Sutherland, of the Financial Strategies Group, is an investment adviser who has worked in the industry for the past 30 years. She’s also the author of several best-selling books.
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