You will be able to explain mental accounting and spot the mental accounts you use yourself.
Before you read any further, write down one thing you say about your own money. Common ones are "that's my bonus money", "I don't touch that", "it's only ang bao money" and "the dividends are for fun". A phrase like this tells you that you keep a jar for that money in your head, and that the jar has a rule about how the money can be spent. Very few people ever write their jars down, so the way you talk about money is the easiest place to find them. You need to find a jar before you can judge whether its rule is doing you any good.
In a shop, a dollar buys the same thing wherever it came from. People still keep money in separate jars in their heads and give each jar its own rule. Richard Thaler named this habit mental accounting. It means sorting money into separate accounts in your mind and handling each one by its own rules, depending on where the money came from, what it is labelled for, or where it is kept. You met Thaler before in lesson 2.4, in his work on the endowment effect. One of those categories on its own is a mental account, or jar: a category you keep in your head for money, with its own rule for how that money can be used.
Standard economics assumes something different. Economists use the word fungibility to mean that money is interchangeable, so a dollar from any source is worth the same as any other dollar. On that view, S$100 from a bonus and S$100 from salary (illustrative figures) buy the same things and should be weighed the same way. In practice, people keep a separate tally for each account. Bonus money seems "extra", so it goes on treats. Salary seems like "real money", so it gets a budget. Savings are kept "for emergencies" and left alone, even when the emergency in front of you is a costly debt.
Tversky and Kahneman showed the effect with a study set at a theatre, using only imagined money. In one version, people pictured arriving at the theatre and finding that a ticket they had already paid for was lost. Far fewer of them said they would buy another. In the other version, people pictured losing the same amount in cash, and more of them said they would still buy a ticket. The amount lost was the same in both versions. The difference was which account the loss came out of. A lost ticket is charged to the "theatre" account, which then feels overspent. Lost cash is charged to a general account, and the theatre budget is left as it was.
Most mental accounts form in one of three ways. Source is where the money came from: salary, a bonus, ang bao, a tax refund, an investment gain. Purpose is the job you have given the money: rent, holidays, a wedding, "fun". Physical location is where the money is kept: a separate bank account, a CPF account, an e-wallet, cash in a drawer.
Time draws lines as well. Many people treat each month's budget as a closed account, so going over budget in week three feels like a disaster even when the month before finished well under budget.
Darren does several of these at once. He spent S$80 of his Chinese New Year ang bao money on a dinner he would never have paid for out of his salary. He has a savings account he calls "untouchable" and guards it closely. He once took a cash advance rather than move S$500 out of it. He thinks of his CPF as belonging to a future version of himself, so in his mind it barely counts.
Mental accounting is not irrational in the sense of being silly. Putting money into groups makes it easier to manage, because no one can weigh every dollar against every possible use. Mental accounts are a shortcut, and like most shortcuts they work most of the time.
A label can make good behaviour easier. If you label S$200 a month as "holiday", you are less likely to spend it on something else. Sinking funds rest on the same labelling idea, and Money Foundations, lesson 3.2, "Sinking funds: turn a yearly bill into a monthly line", explains how they work. An emergency buffer kept in its own account is also harder to raid on a whim.
A label becomes costly when it stops you seeing that a dollar could do more somewhere else. In Singapore the common versions are:
keeping a large sum in savings while paying high interest on a card or loan (lesson 3.3 covers this) spending windfalls freely because they feel like free money (lesson 3.2 covers this) taking big risks with investment gains because it is "the market's money" treating CPF savings as unreal and leaving them out when planning a home purchase or retirement
A rule can work well until it meets a situation it was not built for. For three years, Darren's untouchable rule has stopped him spending his savings on impulse, and that is worth a lot. The same rule also stopped him using S$500 to avoid the cash advance, and the cash advance cost him far more than the interest his savings were earning.
Start by listening for the labels you put on money, beginning with the phrase you wrote down at the start. Then write down each jar and its rule. Darren's list had five: salary pays the bills and is watched closely; ang bao money is for treats; the untouchable account is never used; investment gains are "house money" and can be gambled; CPF is not real.
Next, read the list back and mark each rule as one you chose on purpose or one that just happened. Until the rules are written down, the two kinds are hard to tell apart. When Darren read his list back, he could see which was which. He had chosen the untouchable rule deliberately. He realised he had never actually decided on the "house money" rule.
Finally, go through each rule and decide whether it helps you with discipline or costs you by blocking a better use of the money. Keep the rules that help, and add exceptions where you need them. Darren kept his untouchable rule and added one exception for expensive debt.
Now make your own list of the jars you use and the rule that goes with each. Include the ones you'd be a little embarrassed to say out loud.
List the mental accounts you use, such as bonus money, savings or ang bao money. Next to each one, write the rule you follow for it.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).