Mental Accounting Part 1 - The Problem

Has anyone ever noticed that brains look a bit like intestines in drawing like this? I guess folding is efficient no matter where it occurs.

As human beings, we're subject to the limitations of the brain. While our minds are amazing and wonderful tools, they also have a tendency to get tripped up and bogged down when presented with particular situations. However, if we can understand some of what makes our minds tick, we can create situations where our brains will perform to the best advantage, while minimizing the times where our impulses get us into trouble. Psychologically, you could call these tendencies "mental models," and while there is some debate about whether that's how the brain actually works, the concept offers a useful approach to counteracting some of our innate weaknesses.

Many of these mental models affect how we deal with money. I was listening to the Freakonomics podcast this morning and they were discussing a potentially dangerous-to-your-wealth mental model called "mental accounting." Here's what happens: people tend to treat money differently depending on the form that it's in. For instance, if you're at a diner and a soda is two dollars, most people would likely be okay paying that if it was with a credit or debit card. On the other hand, if you've only got ten dollars in cash to buy lunch, many people would skip the drink and just have water. The amount that it costs you is the same in both cases, but because the method of payment is different, people treat the money differently.

A similar mindset afflicts most of us when we see something for sale. We look at how much we're "saving" and forget the fact that in order to buy something we have to spend money. We also tend to buy things by looking at how much the monthly payment is, and not how much money in total the actual item is going to cost. Not all of these would strictly be called "mental accounting" to a psychologist or an economist, but they all represent ways in which our skewed perceptions of price, value, and money can potentially cause us problems.

So what to do about it? Next post I'll talk about some strategies to help out our silly brains.