Seth’s Blog on Finance

Can You Afford It? How Mental Accounting Affects Proper Judgment

Most people, if not everyone, use mental accounting on a daily basis when it comes to financial decisions. A common example would be the way a person more readily spends his year-end bonus.

Take one more example: If you were going to spend $100 on an item and realised there was a cheaper source 15 minutes away selling it for $95, would you take the effort to obtain it from the cheaper source? What if the item was $10, and the other place was selling it for $5?

Many people will not bother to take the effort to save the $5 on the first scenario, and yet many will in the second scenario despite the savings being exactly the same amount.

While it is easy to pass the above “test” – one could perhaps have answered similarly to both scenarios – reality is a lot trickier. We rationalise extravagances such as an iPad or an expensive dinner as “one-time off” purchases, spend additional income such as bonuses or ang pow money more frivolously, or buy things we do not need because it was on sale.

Are you framing your financial decisions?

Also, it is common to unconsciously (or otherwise) practise a type of mental accounting called “framing” when it comes to financial decisions. For some, budgets are automatically set aside each year for annual vacations as yearly travels have become habitual and thus perceived as obligatory. Many pay their mobile phone subscription (complete with data plans) and broadband bills every month without complaint because these are things deemed necessary. When it comes to something like insurance, however, some people start to begrudge even the tiniest amount of premium obligation.

Framing causes people to overlook financial decisions that really matter. While it may not be immediately obvious, financial planning instruments like insurance and investments ensure survival – financial survival, that is – beyond basic necessities like food and roof over one’s head. Handphone and broadband bills are duly paid because the utility of these items are very apparent. Is the utility of something like insurance really not obvious, or do people just not want to think about it?

“Reframing”

Perhaps some “reframing” is in order. Suze Orman, an American financial guru with a talkshow on personal finance, has a segment on her show where viewers call in to ask whether they can afford to purchase a particular item and she advises them according to their financial circumstances. I think she decided that people need to reevaluate their priorities when it comes to their finances: