Yesterday, I was over at the Grad Girl’s blog and came across this article where she wonders if she should buy one share of the high priced Google stock (at $505.72 per share). Her thinking is that she has $600 coming her way next week as payment for a magazine article she wrote, and since it is money earned beyond her regular income, she can afford to take the risk. This is exactly how I used to think before (and sometimes still do) and reminded me of what I had read in this book that changed my thinking a bit.
According to the book, this is a form of mental accounting that most of us engage in resulting in us valuing some of our money as less valuable than the other money. Here is an example story used in the book to drive the point home. It is apparently a tale well known in Las Vegas as the "Legend of the Man in the Green Bathrobe". If you have already heard the story before, please bear with me for a minute.
By the third day of their honeymoon in Las Vegas, the newlyweds had lost their $1,000 gambling allowance. That night in bed, the groom noticed a glowing object on the dresser. Upon closer inspection, he realized it was a $5 chip they had saved as a souvenir. Strangely, the number 17 was flashing on the chip’s face. Taking this as an omen, he donned his green bathrobe and rushed down to the roulette tables, where he placed the $5 chip on the square marked 17. Sure enough, the ball hit 17 and the 35—1 bet paid $175. He let his winnings ride, and once again the little ball landed on 17, paying $6,125. And so it went, until the lucky groom was about to wager $7.5 million. Unfortunately the floor manager intervened, claiming that the casino didn’t have the money to pay should 17 hit again. Undaunted, the groom taxied to a better-financed casino downtown. Once again he bet it all on 17 – and once again it hit, paying more than $262 million. Ecstatic, he let his millions ride – only to lose it all when the ball fell on 18. Broke and dejected, the groom walked the several miles back to the hotel.
"Where were you?" asked the bride as he entered their room.
"How did you do?"
"Not bad. I lost five dollars".
Now this is something familiar to many of us that have visited Las Vegas. Maybe we didn’t win/lose to the tune of millions, but all of us have at some point rationalized the loss of a few dollars (or maybe a few hundred/thousand dollars) that it was not our money to begin with anyway. But when you think of it, if we had not let our winnings ride, and cashed out, it would have become our money and we could potentially do wonders with it. Yes, you can reason that if we don’t take any risks, we will never win big. But the question is why don’t we apply the same reasoning to our own money? For instance, I can safely make the statement that not many of the people reading this article would wager their entire 401K on a single bet, no matter how good the winning streak is, because we all know that the house always has an advantage and we will eventually lose. While we are not willing to take the risk with our hard earned saved money, we throw the caution in air when dealing with "found" money. The risks are the same and since we are talking about our winnings, it is still our money, but the way we deal with is very different since we mentally compartmentalize that money to have less value than the money that we have worked hard to earn and save. This probably also explains why so many lottery winners squander away their fortunes.
Now let us go back to the story of the man in the green bathrobe. All of us feel bad for the man and think he was an idiot to a certain extent. But would you feel anymore bad for him (and think he is a bigger idiot) if he had blown away their wedding gifts instead of the winnings at the table? I would. So, not only do we treat “found” money differently from the "earned" money, we also mentally classify which of the "found" money is more disposable than the others.
This mental accounting can be both harmful and beneficial. For instance, all of us compartmentalize our retirement savings as sacred and usually don’t play around with it. This is the beneficial side of mental accounting that protects our wealth. On the other hand a lot of us are very careless about "found" money. A dollar in found money is still the same as the dollar in earned money. But due to our ingrained mental accounting habits, we tend to treat it with less respect.
Going all the way back to the Grad girl’s article that triggered this post, even though she is willing to take on higher risks (by investing in individual stocks), she is still not careless or negligent in the fact that she plans to invest the money. But most people just burn the "found" money on shopping for clothes or cool gadgets. What makes this worse is that different people consider different things as "found" money. For instance a lot of people consider gifts, bonuses, previously forgotten money in savings account, inheritance or tax refund as "found" money and blowing away that money can be as harmful in the long run as refusing to start a 401K account!
Another harmful effect of this mental accounting is that, we sometimes end up being too conservative with our savings. For instance, we categorize our hard earned money as valuable and hence something not to take too many risks with. In our case, when we have some additional money left over beyond our regular budgeting, we tend to pump it into our mortgage. Now our mortgage has an interest rate of 5.125% and any form of stock/mutual fund investing will yield more than 5.125%. But, investing in stocks entails a lot of risk, whereas paying off the mortgage ensures guaranteed returns. In the long run, this thinking will probably cost us a pretty big chunk of change :(
So, in summary, here is what I hope you take away from this article:
- We all have a tendency to resort to mental accounting and treat some money as more/less valuable than other.
- Mental accounting can protect us from squandering away our saving, while at the same time cause us to spend our found money recklessly.
- Whenever possible consciously try to avoid being too conservative with "saved" money and too liberal with "found" money.
- Re-evaluate the definition of what qualifies as "found" money.