Decades ago, when Gene Hackman and Dustin Hoffman were struggling actors, Hackman visited Hoffman’s house and Hoffman asked him for a loan. Hackman agreed to grant the loan.
After that, Hackman went to his host’s kitchen to find various mason jars labeled as rent and entertainment and so on filled with money. Of course, Hackman asked Hoffman, if there was any money in the jars, why did he need a loan? To which, Hoffman explained that the food jar was empty.
It’s a story Richard Thaler and Cass Sunstein are writing in their new book Nudge: the final edition. While this may sound like a lot of those anecdotes from the movies that come out after the cast is successful, it does contain some serious personal finance lessons.
Money is fungible. It does not distinguish between being stored in the rental jar or the food jar. If Hoffman had had $ 20 in the rent pot, that would have bought him $ 20 worth of food as well. So Hoffman was not really short of money to buy food. Just that he had divided the money he had in different mental accounts in his head, which led him to ask his friend Hackman for a loan.
The interesting thing is that almost all of us indulge in a bit of mental accounting. Take the case of a tax refund. People tend to categorize it as money found in their mind and then spend it freely, like they just got a windfall.
As Thaler and Sunstein write: âPeople are much more likely to splurge on impulse on a big luxury purchase when they receive an unexpected bargain than they are with the savings they’ve accumulated over time. time. ”
But if you think about it, a tax refund is also your income. It’s just that he was stuck with the government and the government took its time to give it back to you. Therefore, it should be treated the same as regular income.
Then there are cases of people having outstanding credit card debt and a lot of money in their savings account, earning 3-4% interest, at the same time. This is because the credit card debt goes into the “mental” loan account and the money from the savings account goes into the “mental” savings account. This leads to a situation where people end up paying a huge amount of interest on credit card debt while earning 3-4% interest on savings accounts.
As Thaler writes in Bad Behavior: The Making of Behavioral Economics: “Money is fungible, meaning it doesn’t have labels restricting what it can be spent on … Failure to treat various pots of money as fungible.” .. [mental] accounting … feasible. “
Insurance companies also play on this by selling different investment plans to save for children and for retirement. At the end of the day, you have to save and that’s the most important part, but people have different mental savings accounts in their heads and insurance companies take advantage of that.
Thaler and Sunstein discuss the dot-com bubble of the 1990s and the real estate bubble of the 2000s in the United States, and how mental accounting contributed to it. As they write: âMental accounting contributed to the surge in stock prices in the 1990s, as many people took more and more risks with the rationale that they only gambled with their earnings. in recent years. The same happened with speculative real estate investors a few years later. “
In fact, it’s safe to say that the same is happening in the stock market in India and other parts of the world right now, with people taking more and more risk by filing their earnings in a separate mental account.
To conclude, mental accounting is something we need to be aware of when it comes to managing our hard-earned money and then making sure that we don’t make the fundamental mistakes that we end up making because of it.
Vivek Kaul is the author of Bad Money.
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