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MENTAL ACCOUNTS

Why the more an item costs, the more careless with money we are, why we should all use psychological moneybags and how certain budget airlines could have saved themselves a lot of grief.

IMAGINE YOU ARE on a seaside holiday and you decide to hire a bike to cycle along the coast road. You walk along the promenade checking out the prices. The first hire shop you find is charging £25 a day, but then you see a sign for another shop that offers a bike for just £10 a day. The second shop is a 10-minute walk away, but with a price difference like that, maybe it’s worth checking out the cheaper bikes. As long as they look reasonably roadworthy, you can hire one of those instead and congratulate yourself on saving £15, enough to pay for a second day’s cycling or a nice lunch in a café on the cliffs.

Now imagine that you are back home and are buying a new car. In the first showroom you find one you like for £10,010. You want to check you are getting a good deal, so you go to a second showroom 10 minutes away. They have much the same car for £10,025 (this might sound unlikely, but for the purposes of these experiments you need to bear with it). Is it worth going back to the first shop to save £15? Almost certainly not. For a transaction that big, a difference so small feels inconsequential. Yet the sum you could save is exactly the same as with the bike hire. In the earlier example, you are delighted with that saving. Now you dismiss it.

Countless studies have demonstrated that we constantly make judgements like this, viewing a saving as a proportion of the total cost, rather than as an actual amount of money with a determined spending power. This is called relative thinking, and it is particularly common among people who are comparatively affluent.¹

This struck me forcefully when my husband and I moved home recently. It involved the largest financial transaction of our lives. London prices, so hundreds of thousands of pounds: a huge commitment, and one we weighed up carefully. Yet we behaved exactly in line with the research which shows that the bigger the purchase, the greater the likelihood people will take little care over associated costs. Having made such a massive outlay on the house itself, we should have been keen to save every penny we could on other aspects of the move. Yet we didn’t check that the solicitor handling the exchange was offering a competitive rate; we simply used the one we’d been to last time we moved. Likewise we took a friend’s advice – ‘They’re not the cheapest of all, but they’re really good and it makes life a lot easier’ – when it came to hiring a firm of furniture movers. In the context of buying a house, a few hundred pounds – which usually we would be so careful about – felt neither here nor there.

Not everyone can be so cavalier of course. The Indian economist Sendhil Mullainathan asked people in poverty attending a soup kitchen whether they would be prepared to travel for 45 minutes to save $50 on a household appliance. ² He knew all about the research famously done by Daniel Kahneman and Amos Tversky, which showed that people tend to make decisions of this type within the context of the original price.³ In these cases, if a household appliance cost $100 before the markdown, then a 50 per cent discount would make the journey worthwhile, but if the full cost of the item was $1,000 it wasn’t worth bothering with a saving of $50. What Mullainathan showed was that the people in the soup kitchen couldn’t afford to think this way. They weren’t swayed by the initial price because whatever that price was, a $50 saving for them was a sum of money they couldn’t afford to forgo.

On the face of it, theirs was the more rational behaviour. But does that mean that richer people are being wholly irrational? Not necessarily. We factor into our thinking not just the financial saving but the value of our time, which in some cases is more precious to us. Unlike the people at the soup kitchen, we often consider we are – to use the cliché – ‘money rich, but time poor’.

Yet we don’t behave entirely consistently in making these calculations. Many of us spend hours online, finding the very cheapest deal on a flight or a rail ticket and saving relatively small sums in the process. Now that might be sensible for people who can hunt for bargains in the office (without the boss seeing), in which case they’re making the saving and the firm is paying for the time. But I work freelance from home a lot of the time and do the same thing. I’ve never calculated it, but it would almost certainly make more financial sense for me to spend the time working. Yet in this instance, the lure of a cut-price deal is irresistible. Moreover, research has shown, we aren’t prepared to spend the same time to review much bigger, ongoing financial commitments.

To take one example: in the UK, people have the option to change energy suppliers to find the best deal, but research has shown only 1–10 per cent of people regularly monitor prices and save money by switching.⁴ And this, despite the fact that savings on utility bills can run into hundreds of pounds a year.

So why do we make an effort in some cases and not others? Sometimes it is to do with necessity. We have to choose a train ticket because we need to get somewhere, but we don’t have to bother changing electricity supplier. But there is another reason. We hate committing ourselves to future work. The first stage of switching energy supplier is easy enough to do, but it involves more of a commitment than making a one-off purchase. There will be the hassle of reading the meter at a future date, sending the information off to the new supplier, checking the direct debits are working correctly and so on. It’s all a bit of a chore. And of course the reward is a saving in the future, not the instant gratification of shopping in the sales, where you’ve paid less than you might have done and got something shiny and new straight away.

What should be clear from these examples is that the idea that every pound is worth the same to every one of us – a concept that underpins our system of monetary exchange and which we all take for granted – is not true at all, psychologically speaking. Indeed each of us individually puts a different value on each pound we have, depending on the circumstances. From one moment to the next, we consider the money we have differently from the money we spend.

PSYCHOLOGICAL MONEYBAGS

Some years ago, I interviewed the Nobel prize-winning psychologist and best-selling author Daniel Kahneman.⁵ He told me one of his all-time favourite thought experiments, which is something of a classic in behavioural economics. It involves a woman who has spent $160 on two theatre tickets. She is looking forward to the show, but when she arrives at the theatre she can’t find the tickets. She empties out her bag. She goes through her pockets. No sign of them. She feels slightly sick as she thinks of the large sum of money she’s wasted. But what about the show? Will she spend another $160 on replacement tickets, or will she just give up and go home?

When Kahneman tested this scenario with a sample of people back in the 1980s, nearly nine out of ten assumed that having lost the tickets the woman would forgo seeing the play.⁶ But what if the scenario was slightly different?

This time, the woman hasn’t booked in advance. Instead she has brought $160 in cash with her, ready to buy tickets at the box office. But when she gets to the theatre she opens her purse and sees that the money is somehow missing. Does she use her credit card instead?

With this scenario more than half of the people Kahneman questioned changed their answer and said yes. So why is it okay to in effect pay twice for the tickets in the second scenario, but not in the first?

The theory advanced by the economist Richard Thaler, famous for the behavioural theory ‘nudge’, is that we have different ‘mental accounts’.⁷ We assign different characteristics and purposes to different portions of our money. ‘Spending money’ is different from savings. Money you win in a bet is different from money you earn. Even as an adult, the £10 note sent by a great-aunt in a Christmas card is more exciting than the £20 note I’ve just collected from a cash machine. These mental accounts aren’t generally organised like real bank accounts. We don’t make precise, conscious deposits into them or monitor the balances to avoid overdrafts. Indeed, most of the time, most of us are barely conscious of them. But they can nonetheless exert a powerful influence over the way we use our money.

For Thaler, the explanation for the different attitudes above would run as follows. The theatre tickets come from a mental account devoted to entertainment and making a double purchase out of that account after the tickets have been lost feels unduly extravagant. But lost cash is different: it sits in a ‘general’ mental account, and there’s still money left in there to spend. For Thaler, this explains why so many more people said the woman would still buy tickets if she’d lost the cash than if she’d lost the tickets.

Thaler first coined the term ‘mental accounts’ in the 1990s. But other researchers also described similar ideas. In 1982, researchers in Japan found that even within the single category of ‘spending money’, women divided their cash into nine mental accounts or ‘psychological moneybags’, as the researchers termed them: daily necessities, small luxuries, culture and education, personal fortune, security, clothes and make-up, going out, pocket money and raising the standard of living.⁸ The women judged the value of an item not by comparing it with all the items they might wish to purchase, but by making a comparison with other items in the relevant moneybag. For example, oranges sold on the train on a family daytrip were more expensive than oranges in the local store, but the women were happy to pay the higher price because the money was coming from the ‘going out’ moneybag, which was used for special and therefore pricier items, rather than from the mental account for the daily necessities, so a different judgement about the cost was made.

It’s pretty intuitive when you think about it. Maybe a bottle of gin is something you always have in the house, in case visitors ask for a gin and tonic. When it runs out, you get some more from the supermarket and it goes on the food and drink bill. You pay £20 for it at the very most. Yet on holiday you might agree to pay almost half that for a single gin and tonic in a bar with a great view, but you don’t resent it. Why? Because the money is coming out of a different mental account.

Now you might think having these accounts would make us careless with money. But in fact we are not. We don’t throw all our money into the high-end and ‘fun-stuff’ accounts. We assign it quite carefully, putting larger amounts of money into the more serious mental accounts, from which we spend more, but with a keener eye on the price.

Matsutake mushrooms are the caviar of Japan. They grow around the roots of trees such as red pines and have fat stalks that can reach 20 centimetres in height. They have a strong smell and a spicy, some say cinnamon-tinged taste. Gathered by hand from September to November, they are hard to come by – and so very expensive. Today, depending on the size of the harvest, they can cost as much as $800 a kilo. The researchers found that back in 1982, they were similarly pricey. To spend $50 on mushrooms was a considerable outlay. Spending $50 on big bags of rice was fine because that money came from a general grocery account, but money for matsutake came from the precious and smaller luxury account, so this was not a decision to take lightly.

We also assign our money to different timeframes in our minds. Money for today, money for tomorrow and money for a rainy day. Through the creation of mental accounts, we are able to make quick judgements about when to buy something and what it’s reasonable to spend in different situations. They help us to exert self-control over our spending.⁹

Some people go as far as to set up separate bank accounts to reflect these mental accounts, even if that means paying interest on the debit in one while others are in credit. It’s irrational in one way – overall you are losing money; but understandable in another – you’ve worked hard to build up that savings nest egg and it feels wrong to raid it to pay this month’s credit card bill. Banks do offer mortgage deals where the interest you earn on savings is offset against the interest on your mortgage, but still 98 per cent of people in the UK in 2014 chose to separate their savings and their debts.¹⁰ We don’t like the idea of one big tally, especially when there’s a mortgage involved, because then we’ll always feel we’re massively in debt.

Our use of mental accounts also helps to explain why we make judgements about the value of discounts within the context of the total price. It all depends on which mental account the money comes from.

When my husband and I bought our house and failed to shop around for a solicitor, it was partly because these fees seemed inconsequential in comparison with the price of the house. But it was also because we were chalking the fees up to a particular mental account, in this case a special one – the ‘once in a lifetime buying a house’ account. In reality of course the money we were shelling out to the solicitor was coming from my actual current account, which was rapidly looking very empty.

It is very important that we can assign money mentally in this way. If we didn’t do it, we wouldn’t take risks or make long-term investments, and we wouldn’t have the economic activity and the prosperity to show for it. Mental accounts allow us to escape from the crippling financial caution that could otherwise grip us. In this sense, our evolving psychological attitudes to money allow modern economies to function.

But difficulty sometimes arises in trying to force our minds to put money into the appropriate psychological moneybag. Around 15 years ago, my husband and I decided to get rid of our car. Living in London, we found we were using it less and less, not least because parking spaces where we lived at the time were so precious that we were reluctant to surrender the one we had by using the car. It got to the point where, on the rare occasions we did decide to drive, we couldn’t remember where the car was even parked. On one occasion, we wandered around for more than half an hour and then said to ourselves it was probably better that we take the tube after all, because if we drove we would only have had to spend ages later finding another elusive parking space.

It was getting ridiculous. Our Renault 5 was not so much a car as a white elephant. Selling it to someone who would use it regularly was clearly the sensible thing to do. Yet doing that would mean we would always have to take public transport. In London, this is generally reliable, but what about on late nights or if we wanted to travel out of the capital?

No matter, my husband said, just think of the thousands we’ll be saving over the years. With no insurance, road tax, MOT, repairs or petrol to pay for, the money we saved could easily justify paying for a late night taxi home from a friend’s house or a hire car for a weekend away.

His argument was logical and sensible – and we sold the car. But all these years later, I still find it hard to take the fare for a black cab from a mental account for everyday transport. Petrol and garage bills didn’t feel like luxuries, but a taxi still does. So I rarely take one. Now that we have a garden and want to be able to fill a car boot with plants, we’ve started to wonder about buying a car again. In fact taking a taxi, and even having it wait for us, would still be cheaper, yet we can’t quite bring ourselves to do it. It feels so extravagant to take taxis to garden centres. Yet a car, although far more expensive, seems reasonable. The explanation, I suspect, is that I’ve grown up in a culture where a car is considered essential for everyday life. A hundred years ago, things would have been different. A car would have been a luxury and paying cab fares relatively commonplace. In the future that might be true again. Maybe we’ll be summoning driverless cars to come and get us instead of owning a car at all.

SETTLING OUR ACCOUNTS

So far, we’ve been considering mental accounts as if they are fixed things that we carry through life. In fact, with every transaction we open a new temporary mental account. Take buying an air ticket. These days flying is so common that a flight has almost passed out of the luxury item category. But it’s still not an everyday purchase for most of us, and we are keen to assign the appropriate sum to the ‘flight to wherever’ account. As long as we don’t go over that assigned sum, we’ll be happy.

But the account isn’t mentally closed until we’ve taken the flight, landed safely, collected our bags and got to our home or hotel. If an air traffic controllers’ strike means we have to pay to travel by train instead, we are likely to add that unforeseen cost to the mental account for the trip and will now consider we made a ‘loss’ on the account. We don’t generally chalk that extra train fare up to a ‘rainy day account’. This was a particular trip for which we opened a particular mental account. So any unanticipated expense assigned to the account feels psychologically painful, almost irrespective of the actual amount.

To appreciate the point further, just consider the following example: instead of getting a cheap air ticket by booking long in advance, you pay top price because you only managed at the last minute to get the time off to attend your friend’s wedding. You know you’re paying perhaps a couple of hundred pounds more than you would have done otherwise but in this instance you are happy enough to pay it. After all, you’re unexpectedly getting the chance to be there for your friend’s big day. Yet change the circumstances back to having booked a cheap flight and then finding you have to take a train because of an air traffic controller’s strike. The extra cost might be the same, but your response, I’d bet, will be very different.

The same mental processes, and mental anguish, happen when you decide a purchase is good value, only to discover that there are extras such as booking fees or seat selection charges. If the initial price had been a bit higher you might not have minded: you would have factored it into your mental account for the flight, but once you’ve established in your mind that the original price is what you’re paying, any extra cost feels like a loss on the account or, worse still, a fine.

Because our minds work in this way, I’m surprised that certain budget airlines took so long to realise that their notorious practice of adding extra charges later in the booking process annoys people. If the executives of the company had taken the trouble to look at the welter of psychological research (which they’re not alone in ignoring, I should add), they would have realised that what they thought was a clever business strategy was actually causing long-term brand damage. Our mental accounting makes us acutely alert to anything that feels like a rip off. In other words it helps us to exercise mind over money.

It’s a finding I pick up in the next chapter. The strongest psychological reaction we experience in relation to money is the one that occurs when we know we are losing it.