Understanding the psychology of money The way people perceive monetary gain and loss cannot always be explained rationally
Dilip Soman
Almost every rational theory of business and economics works on the premise that the only thing that matters in an economic transaction is the dollar value of the transaction, not the source of the funds or the physical form it is in. Sages and mothers also seem to agree when they write that “a dollar is a dollar” and “a penny saved is a penny earned”. However, recent research shows that a penny saved is often not a penny earned. Consider the following examples:
1.
A store offered a $25 discount at their branch 10 kilometres away. Would you drive through bad traffic for the $25? We find that only 14% say they’ll drive if the discount is offered on a big screen TV costing $2,500. But as many as 75% say yes when it is offered on a $75 portable CD player.
2.
If you paid $100 to buy a ticket to a basketball game and lost the ticket, would you buy another ticket? Most people say no. But suppose you lost $100 in cash—would you buy a ticket? Most people say yes. Why? In both cases, you have lost $100 due to your carelessness, yet we find a big difference in results.
3.
In Hong Kong, people were given $500 to spend. Some people who received a single $500 note held on to it for longer, but once they started spending, they spent it all quickly. Others were given five $100 notes—they started spending sooner but took a longer time to spend it.
4.
In the US, people get income tax refunds after (extra amounts of) taxes are withheld at source throughout the year. This is their own money which the government has kept interest free for a year. Yet, most people who get refunds spend that money on hedonic purchases—vacations, massages, stereo systems—things they would never spend their salaries on. More generally, taking money away from people and giving it back to them makes them spend it more easily!
None of these behaviours can be explained by any rational economic basis. But if you find yourself exhibiting similar behaviours, fret not! According to behavioral economists (who study the psychology behind economic decisions), you are a mental accountant! This theory was initially developed by professors Thaler, (Late) Tversky and (Nobellaureate) Kahneman, and can be defined as the process that people use to track and evaluate economic transactions. The theory basically says that all of us behave, in essence, like accountants and has two central components. The first relates to how we evaluate money and the second to how we categorise it.
Judgments about a sum of money are meaningless without a comparison (a reference point). We compare our salaries to others around us (or to our previous salary), we compare prices across stores. A $25 discount on a $75 product looks huge—on a $2,500 product it looks tiny. If an outcome is better than the reference, the theory calls it a gain, otherwise a loss. And losses hurt us more than gains make us happy—this is called loss aversion and it simply suggests that the value people place on money and objects increases after they possess it. When taxes are withheld at source, we don’t experience a loss because we never see the deducted money. And when we get our money back, it seems like a gain and hence spent on indulgences.
Next, categorisation. Suppose you are passing by a coffee shop. Should you buy a coffee for Rs 20? If you behave according to economic theory, you should calculate the benefit you get from the coffee relative to other things you could buy with the money. This is a complex process and if we followed it for everything we buy, we would have little time for anything else. So, we have mental accounts—an informal budget that says that you are entitled to one coffee everyday, and similarly for other categories of expenses (say food, entertainment, clothes…).
We might also have ad-hoc budgets. When you buy a $100 ticket, the mental accountant sets up an account called “basketball” with a “minus 100” in it and a budget of $100. If you lose the ticket, that’s too bad—you have no money left in the budget and hence you can’t buy a ticket. But if you lose the cash, that’s ok because that comes from the “general expenses” account and you still have $100 left in the basketball account. Note, though, that once you have a “minus 100” in the account, the only way you can close it with a profit is to consume whatever you paid for. Economics tells us to ignore sunk costs, but mental accounting explains why people who have a season ticket tend to go to the fifth days of boring test matches just because they have paid for them (its called the sunk cost effect).
Money could also be categorised differently as a function of how it is earned. Salespeople and waiters typically categorise their income into a (steady) salary component; an (unpredictable) commissions/tips component; and a (lumpsum) bonus component. What’s more, they spend the money differently—salaries go towards rent and paying necessities, tips towards small indulgences like dinners at restaurants and small vacations, and bonuses on major purchases like cars and foreign vacations.
One other interesting manner of changing these categories is to change the physical form of a transaction. Back to the season ticket example, the sunk cost effect is very strong if the season ticket is presented as a booklet of five coupons rather than a pass. If there is a coupon for the fifth day’s play, it is more of a reminder of the past expenses and it psychologically forces some people to go. Similarly, people spend notes of different denominations differently.
All of this sounds interesting, but you’re wondering what importance mental accounting has for business. Research shows that mental accounting has huge implications for investment decisions, for retirement planning, for credit card spending, in marketing—and for helping people make better decisions. How? Stay tuned!
Why people hold on to losing stocks, and other mysteries
Dilip
Soman
peeps into the mind of the ordinary person to unravel the thought process behind their decisions to earn, spend, save and invest
Last week, I wrote about mental accounting—the science behind how people evaluate monetary transactions. This phenomenon has wide implications because many things we do involve the valuation of money. The decisions influenced by mental accounting include retirement planning, spending and saving behaviours, shopping decisions and many others.
Let’s begin with something that most of us obsess about—our portfolio of stocks and bonds. Finance researchers have, for many years, documented a phenomenon called the equity premium puzzle. Stocks have outperformed bonds over the last century by a surprisingly huge margin. Yet investors who have long investment horizons seem to have more bonds in their portfolios than rationality would dictate. If they plan to hold on to their portfolios for many years, why not simply invest in stocks?
Suppose I give you a chance to play a bet—if I toss a coin and it comes heads, I’ll give you Rs 2,000. If it’s tails, you give me Rs 1,000. If you’re like most people, you will not take the bet because of loss aversion. The possible loss of the Rs 1,000 might hurt you more than the gain of Rs 2,000. But suppose I told you that is I will toss the coin hundred times, give you the results all at once and give you a net amount based on how many heads of tails you get. Most people are now happy to accept the bet. Put differently, the loss hurts if it is seen in isolation, but when aggregated over time it doesn’t pinch at all.
In the language of mental accounting, if we do the accounting at the level of an individual bet, we don’t accept the bet, but if we account over all 100 bets, we accept it.
Stocks are a lot like coin tosses compared to bonds. Over the long run, the bet (stocks) are well worth it, but if you view your portfolios too often you will sometimes see your stock going up (gain) and sometimes going down (loss). And since the psychology of the loss is so strong, people tend to sell stock and find comfort with bonds.
The basic problem is that we look at our portfolios too often. The prescription—avoid looking at portfolios too often.
There are other interesting stock market phenomena. When a share you buy for Rs 100 falls down to Rs 50 and climbs back again to Rs 100, you might feel happy about the Rs 50 gain from the low point and sell the share. You might have just sold a winner. If you bought another share for Rs 100 and it kept plummeting, you may experience loss and hold on to it in the hope that it will climb back to Rs 100 and you can close your mental accounting. You will be holding on to a loser. Research shows that people tend to hold on to losers too long and sell winners too soon because of mental accounting.
Here’s another seemingly unrelated puzzle. Several behavioural economists studied the work patterns of taxi drivers in New York (but this might as well be Singapore or Mumbai) who are free to set their own working hours. Some days are good—perhaps it is raining, or the trains are not working, or there is a big convention in the city and the demand for taxis is high, and so is the earnings potential. Economics states that we should work more on good days, but the researchers found that drivers tended to do quite the opposite—they worked longer hours on slow days. Why? Mental accounting again is at work here. Taxi drivers tend to account for their money one day at a time, and they set daily earnings target for themselves. On a busy day, they reach the target sooner and go home. On slow days, they have to work longer to meet the targets. Mental accounting on a daily basis rather than a longer period causes them to allocate their labour suboptimally.
On to more topical issues like spending behaviours, credit cards have been often blamed for causing people to overspend. It’s easy to see why from a mental accounting perspective. When you pay by cash or cheque, the memory of the payment is stronger. So when you are faced with a spending opportunity on a luxury item and you’re looking to what you’ve already spent on luxuries to calculate the surplus in your mental accounts, this process is more accurate for cash and cheques than for credit cards. Hence, when we habitually use plastic to pay, we might tend to believe we have more disposable budgets available to us than we actually do, and that’s why we spend more. The prescription is simple—every time you use a credit card, update your records and keep track of how much you’ve spent.
We’ve earlier blamed “narrow” mental accounts for the equity premium puzzle and the travails of the taxi driver. However, these very same narrow mental accounts can be used positively to influence behaviour.
Consider retirement savings. Suppose you have a goal of saving Rs 100,000,000 and suppose that over the last 20 years you’ve saved Rs 50,000,000. Now you are faced with a tempting purchase that costs Rs 5,000. Should you spend it or add it to your savings? Rs 5,000 seems like a mere drop in the Rs 50,0000,000 ocean. But suppose you saw that your investment account had been partitioned into smaller units—let’s say “Savings in 1987” and so on. Rs 5,000 will presumably not seem that small in the context of the “2007” account, and hence it is more likely to be saved. In a series of studies using related materials, I and colleagues find that this is indeed the case.
Research in mental accounting has covered very many more domains than can possibly be described in a newspaper article. Sometimes they help, sometimes they hurt. Love it or hate it, there is no way but to acknowledge the existence of this powerful phenomenon for our behaviour and its varied consequences for business and the economy.
The author is professor of marketing, Corus Chair in Communication Strategy and Senior Fellow, Desautels Center for Integrative Thinking at Rotman School of Management, University of Toronto
