Mental Accounting: How Math Mind Games Bust Our Budgets

A guy walks up to a high roller in a casino and asks: "Could you help me out? My wife is sick and needs medicine that I can't afford. Just two hundred bucks. Please. I'm begging you."

The high roller says, "That's some sad story, pardner. But how do I know you're not going to gamble with that two hundred dollars?"

The guy says, "Oh, I got gambling money."

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What the guy really has, aside from chutzpah, is a bad case of mental accounting. This is a psychological phenomenon that causes us to mentally separate money into different accounts -- such as money for bills and money for vacations. (See our full special report on investor psychology.)

Sometimes that can make sense. But it can also make us behave irrationally. Behavioral-economics pioneer Richard Thaler, who first described the phenomenon, gives the example of cab drivers who tend to knock off for the day after they've reached a certain level of income -- in other words, after they've filled a certain mental account. On a rainy day, when cab use is highest, they'll hit their mark quickly and knock off early. On a slow day they'll work longer. Irrationally, they're working fewer hours when making money is easy and more hours when it's hard.

Mental accounting leads us to hoard money in a savings account that earns 0.3% interest while keeping a high balance on a 15%-interest credit card. We like the psychological comfort we get from having money in the bank, even though transferring cash from savings to pay off a credit-card balance can essentially "earn" us a quick 14.7%.

Under the rules of traditional economics, mental accounting shouldn't exist because money is fungible -- one dollar is exchangeable with another dollar. But we all know that's not how it works. For instance, it's painful to use dollars from your vacation fund to replace a broken furnace.

And we regularly suck the fungibility right out of money. Instead of giving perfectly liquid cash as a present, we buy someone a gift card. That limits the money's utility, but it also scores in the recipient's mental "gift" account.

On a grand scale, the U.S. government learned a hard lesson about mental accounting in 2008. Remember when the feds gave us $96 billion in stimulus money so we'd spend it to boost the economy? Instead, we saved most of it, probably because checks from the U.S. Treasury don't go into our mental spending-spree account. (Uncle Sam should have mailed us $96 billion in gift cards.)

How to Benefit

Financial planners recognize that mental accounting is a powerful force, and they use it to their clients' benefit. For example, they know that many clients enjoy the thrill of trading securities. "It's something that's deeply rooted in a lot of us, and I don't try to change it," says Ara Oghoorian, a planner in Studio City, Cal. Instead, Oghoorian and other wise planners sequester trading in a small account -- 5% of total assets at most. If you have the itch to trade, scratch it with a mad-money account. It will save you from taking unnecessary risks with the lion's share of your investments. Planners also encourage investors not to view their portfolios as a collection of different accounts. If you do, you may be tempted to sell a specific asset that tanks, or buy more of one that has excelled -- in other words, sell low and buy high. Regard your portfolio as one account for a specific goal.

One particular quirk of mental accounting may be holding investors back from earning higher returns in this low-rate environment. Planner Bill Parsons of Scottsboro, Ala., sees clients who are wedded to the idea of an income account that collects interest payments from bonds and CDs. Often this account acts as a substitute for the paycheck retirees once received; but with interest rates so low, investors don't earn much.

The key, Parsons says, is to move clients from a mental account labeled "income" to the idea that "total return is the only thing that matters." He encourages them to hold more stocks and take gains for income.