More mental accounting forms: the “endowment effect” and “nudge theory”

More mental accounting forms: the “endowment effect” and “nudge theory”

So I found out there’s a term for what we were talking about the other day on treating your money differently depending on how you get it!

It’s called “mental accounting” and apparently is a pretty popular thing, based on work by Nobel Prize recipient, Richard Thaler 🙂 Here’s a description of it from Investopedia:

Mental accounting refers to the tendency people have to separate their money into different accounts based on miscellaneous subjective criteria, including the source of the money and the intended use for each account.

That about sums it up! Haha… Although not sure about the 2nd part of the explanation:

The theory of mental accounting suggests that individuals are likely to assign different functions to each asset group in this case, the result of which can be an irrational and detrimental set of behaviors.

I will admit to the irrational part of treating your “extra” money differently since money is still money no matter where it comes from!, however is it really that detrimental to your financial well being?! I don’t think so, at least in my particular case… I think you get into much more trouble when you’re playing around with your “core” income than your side pots. But who am I to postulate – I’m no Nobel Prize winner 😉

Still – pretty neat there’s a TERM for it! Thanks to everyone who let me know about it, particularly Shannon who then sent over this fantastic article on all the ways mental accounting can affect us:

Four things Richard Thaler taught us about irrational behaviour

The first two we’ve already covered (#1. was a breakdown of what “mental accounting” is – i.e. the way we process money differently, and #2. was around “house money” – when you tend to be more risky with winnings because it feels more like someone else’s money), but here are examples #3 and #4 which I found equally as fascinating (and guilty of as well!):

#3. The “endowment effect” — The idea that we tend to overvalue what we own simply because we have it! “Thaler demonstrated the effect in action in a classic experiment in the 1980s while working at Cornell University in the US. He randomly handed out free coffee mugs to students and asked those who had received mugs how much they would sell them for, and those who hadn’t how much they would pay for them. The typical recipient of the mug demanded $4.75 but the typical buyer offered $2.25. The mere possession of the mug—which in this case was accidental—caused people to value it highly.”

I catch myself doing this alllll the time with new coins I add to my collection, haha… As soon as it’s in my possession it feels as if they’re 10x as valuable! Especially the *longer* it’s in my possession for 🙂 I always thought it was maybe due to me being able to appreciate them more as you have more time to look at them/research them, but I suppose that doesn’t hold the same weight for non collectible things like mugs, etc…

Same goes for anything *sentimental* too. I always perceive the items that have attached memories to be much more valuable than the actual items themselves, which of course is nonsense and why so many of us can’t ever get rid of our stuff! (Or price them too high when we try – hah!)

#4. The “nudge theory” — This is one of my favorites, and something I wish became more mandatory across our country. “Thaler’s nudge theory is especially relevant to retirement planning. Research shows that when employees are automatically enrolled (given a “nudge”) into a retirement plan (with the option to withdraw), far more people sign up than would have if they had to enroll themselves.”

YES!!! Because people are lazy!!! Even with things that they say are important to them! So you always have to find ways to use this to your advantage, and “forcing” them to automatically enroll in things is exactly the key to ramp up savings… (though of course the same trick works in opposite ways too, like signing up to subscription services that you’re then too lazy to cancel later!)

Thaler also co-designed something called the “Save More Tomorrow” plan (SMT), in which people commit to saving more later, but actually opt into the plan *now*.

As Thaler explains, “self-control is easier to accept if delayed rather than immediate.” And, as planned increases are linked to pay raises, it is meant to diminish the effect of loss aversion – the tendency to feel losses larger than gains.

So basically people signed up for this “Save More Tomorrow” plan early on, and then later when they got their raises a portion of it was automatically siphoned away into savings and they didn’t even notice it. Because they didn’t even have a *chance* to notice it! Haha… The first go at it was so successful – quadrupling employees’ savings rates from 3.5% to 13.6%!! – that it got disseminated around and is now apparently used by millions of people. I guess internationally, since we sure don’t have this here?!

Anyways, all this to prove yet again that emotions are very much a part of our finances, and can be used to help AMP them or DESTROY them depending on how they’re harnessed 🙂

Personally I try using my energy to AMP it, but Lord knows there are times where I might as well have just lit my cash on fire! Haha… But we live and we learn! And the more we continue learning about *ourselves* in particular, the better we’ll recognize when this “mental accounting” is in play.

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