Imaginary Budgets

Behavioral Finance is the intersection of economics and psychology and ultimately comes down to biases in decision-making. Our decisions are predictably irrational and are not always in our best interest, from holding stocks that are losing value and selling stocks that are gaining value, to eating that sweet chocolate cake even though we’re on a diet. Understanding these common biases can allow us to catch ourselves before they become a problem, and ultimately live happier, healthier, and richer!

Today, we’ll explore one of the most common biases in Behavioral Finance: mental accounting. Let’s see what this looks like by going to an {Insert-Favorite-Music-Artist-Here} concert!

Concert Adventures

Let’s say you and your friend have tickets to a {Insert-Favorite-Music-Artist-Here} concert! These tickets cost you $60, and you bought them online the day before. It’s the day of the concert, and when you get to the concert hall, you realize that you forgot your tickets at home! 😭😭You live far enough away where you would miss a large chunk of the concert if you were to go back and get the tickets, so your only option is to either go home or buy last-minute tickets for $70. Would you buy the tickets or go home?

Now let’s say you didn’t plan that much ahead and decided to buy tickets on the day of the concert. On the way to buy your ticket, you get mugged by “Oddly Specific Mugger”, who forces you to give up $60 or else your second cousin will be held hostage. Luckily, you have just enough money left to afford the last-minute tickets ($70). Would you buy the tickets or go home?

(Credit: XKCD)

$60 Poorer

Did you say no in the first case and yes in the second? Many people, given a similar choice, did, but they are essentially the same. In both cases, we lost $60. However, in the first case, we spent those $60 on the tickets, which came out of our “entertainment budget” (a make-believe mental budget). In the second case, we just lost $60 random dollars, so our “entertainment budget” has more to spend, even though we’re still $60 poorer.

This is mental accounting, and it can cause you to spend more with credit than with cash or go bankrupt after winning the lottery.

Conclusion

Mental accounting is a super pervasive example of how we don’t always make sense when it comes to thinking about money (or any part of our lives that have some notion of resources).

Action Items

Here a few things you can do to mitigate some of the common pitfalls of mental accounting:

1. First of all, if you don’t already have a budget, make one. 😃
2. Notice which budget categories you tend to overspend on. One way of noticing if you’re falling into mental accounting is to see if you spent the remaining budget before or after you realized you had money leftover.
3. When making your next major purchasing decisions, check your budget and your account balance: the budget tells you how much you could spend, while your account balance will tell you how much it’ll hurt to make that purchase.
4. Repeat after me: “all money is the same” 😉

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Disclaimer: The content on Young, Not Broke is for informational and educational purposes only and should not be construed as professional financial advice. Should you need such advice, consult a licensed financial or tax advisor.