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Mental accounting: How money works in our brain

By | All, Behavioural Science, Financial Behaviour

Did you know we treat money differently depending on where it comes from, where it is kept, or how we label it? In this blog post, I want to introduce you to the concept of mental accounting. A fascinating psychological phenomenon affecting many of our financial behaviours, such as the way we spent and save money or value things for which we’ve paid money. Understanding more about mental accounting could help us design better financial decisions and behaviours. And understand why some people seem to make financial decisions that don’t always seem to make sense or be in their best interest.

Mental accounting: How humans violate the economic theory

Why mental accounting is so fascinating is that it simply explains why 1 euro isn’t always 1 euro. From an economic theory perspective, this might sound foolish. The value of 1 euro and another euro on the same day is equal. We have a whole international money rate system in place that can tell you the exact worth of your euro at any precise point in time. In four digits. Also, economists believe that it shouldn’t matter if you have a 100-euro banknote or five 20-euro banknotes. It is the same amount of money, and you will spend it the same way; after all, they are exchangeable. However, psychological research has shown that humans often violate this rational approach to money. 

This works may be easiest explained by an example described in the landmark paper of Richard Thaler (1), the author of the influential book ‘Nudge‘ and a Nobel prize laureate. Let’s say you have bought a ticket to a concert and it cost you 50 euros. You made your way to the concert venue, you have dressed up nicely, you have arranged a babysitter, and if you say so yourself: you look good. You are more than ready for the evening out that you have anticipated for weeks. You get to the entrance, reach into your pocket to find out that you have seemed to have lost your ticket. After going through all the stages of grief: denial, pain, anger, depression, acceptance, finally, hope kicks in as you see the ticket booth is still open. You quickly head over to the ticket booth to find out you don’t get your ticket reimbursed but have to pay another 50-euro for a new ticket, which is luckily still available.

Okay, same scenario, but just a bit different. You want to see that same concert, again you dress up nicely, sprayed on a bit of cologne because it is a special night out, after all, the same babysitter is there to attend to your kids, and you head over to the concert venue. When you go over to the ticket booth to buy yourself a ticket, you realise the 50-euro banknote you had put in your pocket to pay for the ticket fell out. After almost panicky going through all your pockets, reality sinks in. The 50 euros are gone. Luckily, the time tickets are still available; you have to get out another 50 euros to buy the ticket. 

The interesting question is would you do so in both situations? From an economist perspective, the exact same situation: You have lost 50 euros, and you have to pay another 50 euros to attend the concert. So, there shouldn’t be a difference in the decision you make. However, Thaler’s research found that people in the first scenario are far more likely not to buy a second ticket, whereas people in the second scenario do. 

If you lose cash, it turns out you’re willing to buy a ticket. If you lose a ticket, you do not want to buy a second ticket.

Mental accounting: What is it, and how do people do it?

Mental accounting explains this story. What is mental accounting? It is the idea that people tend to label money. And the moment you label money differently, it gets spent differently. 

People tend to label money. And the moment you label money differently, it gets spent differently.

 So, how do people mentally account? Well, there are several different ways in which people put money into different psychological categories: 

  1. You could mentally account by purpose. You can allocate money to a specific product or service, or objective. This is what happened with the concert ticket. It was assigned to the concert, losing the ticket felt we had lost out on the concert in our mental account. You think you are already in the ‘red’. You are not going to make it worse by spending even more money on the same product. But allocating money to savings is another way to mentally account by purpose.
  2. You could mentally account by time. You could say I will spend X amount per week or budget that many euros each month.
  3. You could mentally account as a function of how you have earned money. If you have put in many hours of hard work to make your money, you will spend it differently if you have earned it by winning a lottery. 

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Mental accounting: The sunk cost effect

Let’s take a look at another way mental accounting influences our behaviour. Let’s get back to the concert. Let’s say you have the ticket, only this time there is a difference in how you acquired that ticket. In the first scenario, you have prepaid for it; in the second scenario, the ticket was a gift. Imagine this situation, on the evening of the concert, there is this raging blizzard storm, and the concert is a two-hour drive away from your home. Would you go to the concert in both scenarios? If you would rationally think about it, you wouldn’t go in both situations. It is much safer to snuggle up comfortably on your couch. However, most people who have prepaid the ticket will make an effort to drive a few hours through a blizzard storm to attend a concert that they (only) paid $20 for. This is caused by a phenomenon known as sunk cost fallacy

If people have spent effort, time or money on something, they will commit to the behaviour related to it; otherwise, they feel they lose out.

The moment you spend money to consume something in the future, our sunk cost effect of mental accounting kicks in. The moment you prepay, you have a deficit in your account. If you cannot consume, then you have to close your account in red. It’s like making a loss. People don’t like making losses, so they rather get what they paid for than perhaps make a better decision not to consume something. For example, if people spent 60 euros on a four-course dinner, but they are already full at the third course, most of them will eat dessert anyway. I paid for it! It feels like a loss not to go or not finish all your plates.

Another example made famous by Richard Thaler is about a man who joined a tennis club and paid a $300 membership fee for the year. After just two weeks of playing, he develops a case of tennis elbow. Despite being in pain, the man continues to play, saying: ‘I don’t want to waste the $300.’ (2)

The sunk cost effect becomes a huge motivator of consumer behaviour.

However, the intensity of the sunk cost effect isn’t always the same; it depends on how closely the cost and benefit are connected. Let me give you an example of how this works. Let’s say you love skiing and you have booked yourself a trip to the French Alps. You got yourself a four-day ski pass giving you access to all the ski lifts for the four days at the costs of € 160. You enjoyed the first three days, and then all of a sudden, the weather conditions change dramatically: Big snows, fog, heavy winds. No skiing conditions that will bring joy. The same scenario, but now you have bought four separate tickets of € 40 with which you can hit the slopes for four days. In which situation would you go out skiing on the fourth day?

This was researched (3), and it showed that people who bought the one ticket would be more prone to stay in. However, the people who had four separate tickets were far more inclined to go out and ski anyway. They felt the €40 burn in their pocket (cost) and want to experience the benefit (skiing). The all-inclusive ticket is, in fact, a form of price bundling. This leads to a ‘decoupling’ of costs and benefits. The effect being it reduces someone’s attention to sunk costs and decreasing a consumer’s likelihood of consuming a paid-for service. In other words,

Price bundling affects the decision to consume.

Now, it becomes interesting how we can use these insights to design for better choice and positive behaviour.

Mental accounting: Using it for better decision-making

Being aware of the human tendency to engage in mental accounting and being affected by the related sunk costs effect can help us develop behavioural interventions that can help people make better decisions. I want to end this blog post with an example of how this might work. 

A lot of people find it challenging to spend less money than intended. You can make this easier for them by partitioning. How does it work? Let me illustrate this with a real-life example that took place in India. In India, there are quite some low-income households with very little spare cash. Salaries are often paid in cash, making it very easy for family providers to spend it, for instance, in the bar, after a hard days’ work. Still, people also needed money for the children’s upbringing, for example. 

Those households typically earned 670 rupees per week (£6,60 or $11,20), and most families only managed to put aside 5 rupees per week (0,75%) (4). The intervention they did is divide the money into envelopes before handing it over to the beneficiary and partitioning it beforehand. It increased the savings rates to 4% (27 rupees per week)(5). What made it even more successful is putting a visual reminder on the envelopes. So, for example, a picture of their children on the envelope contained money for their upbringing.

You could also use this for yourself. We are also more reluctant to spend money we have already mentally allocated for savings. You can distribute very physically, like the envelopes, but think about labelled jars in which you divide your household money. Viviana Zelizer, a sociologist at Princeton, calls this ‘Tin Can Accounting’ (6). The more digitally savvy translation of this is the digital saving buckets many banks offer nowadays, in which you can allocate your savings to specific goals. It will be harder to withdraw money from an ‘ultimate wedding dress’ or ‘summer family holiday’ bucket than from a general savings account.

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We, as humans, often make very emotional decisions when it comes to money. It largely depends on how we have earned, labelled or how our money is kept, how we will treat money and how we value what we bought with the money. This largely influences our behaviour. A euro isn’t always a euro, and a dollar not always a dollar. It may sound illogical, but it will make perfect sense once you understand the concepts of mental accounting and the sunk cost effect. We need to take these psychological phenomena into account if we want to help people make better decisions.


Astrid Groenewegen

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Three Cardinal Sins against Customer-Centricity in Finance

By | All, Financial Behaviour, SUE Amsterdam & Behavioural Design Academy originals

Last week, I was attending a keynote presentation by the CEO of one of the biggest Belgian banks. He was presenting the story of the digital transformation of his bank and he brought it as if it was a visionary story. And although the man certainly had excellent presentation skills, I somehow got annoyed with his storyline. Probably in the first place because it felt like 2007 was back with cliché-slides as “Shift Happens”, “The Consumer is in Control” and “Remember Altavista? Look at what Google Did!”. But the second reason for my annoyance had to do with something more profound. He was preaching the “customer-first”-mantra, while in reality, his story had absolutely nothing to do with customer-first. It was very obviously “Bank-First”, under the disguise of “we want to make it more simple for the customer to buy more stuff”.

In my view, his keynote sinned against three cardinal sins of customer-centric innovation. And I want to argue that you can find these three cardinal sins in every digital transformation pitch by gurus, consultants and managers. So what I want to do is to put the spotlight on each of these three sins and I want to use the next blog post to suggest how you can transform these cardinal sins into decisive action.

Cardinal Sin 1: The customer as consumer at the heart of the strategy

At the heart of all these digital transformation keynotes sits the demanding, narcissistic customer. This customer is said to be spoiled by the speed and simplicity of Google, the absurd logistics of Amazon and the mobile interface-perfection of Apple and Facebook. What follows is that all these corporations assume that it’s exactly this demanding and spoiled attitude what makes this customer so different from the good old days. The CEO shared an example in his keynote of how his bank redesigned a front-office and back-office process to allow a customer to open an account in a couple of minutes on his smartphone. The bank would reward this customer with € 5, allowing him to walk into a Starbucks and buy a coffee just minutes after opening his account.

The problem with this example is that the banker looks at his customer with a “consumer”-frame in his mind. But when you look at the customer as a moody, demanding, click-trigger happy cowboy, and you build your processes and services around this persona, you’re doomed to lose the battle. Because the real challenges where every digital transformation project should focus on, are the challenges and problems that the human behind the customer is facing. And those problems are on an entirely different level: An incapability to build wealth, or to become financially independent. 95% of the people are financially illiterate and could really use some help to construct financial buffers, make smarter investments, generate passive income, etc. Thát’s the real design-briefing for which financial institutions need to develop intelligent answers. A better interface just a simple hygiene-factor for which they do need to catch up. To design your entire digital infrastructure around a spoiled persona is, to put it mildly, incomplete. And to put it more bluntly: out of touch with the real world.

Cardinal Sin 2: Evil KPI’s

Every time you hear Mark Zuckerberg doing an interview, he keeps insisting that the interest of the Facebook-community is central to everything the company does. In a recent interview on Reid Hofmann’s Masters of Scale-podcast, he says: “Our mission at Facebook is to discover where our community wants us to go.” With this mission in mind, Facebook employees conduct hundreds of experiments each day. Mark Zuckerberg is convinced that the world will be a better place if Facebook discovers what people want.

The only problem with this mantra is that Facebook has become a public company in 2012. And once a company goes public, its primal reason for existence is to create shareholder value. And the number one metric to create shareholder value is “engagement”: when as many people as possible, return to Facebook as many times as possible to serve them as many ads as possible.

Facebook-scientists, Facebook-algorithms and the Facebook-AI work really hard to generate a maximum amount of “engagement”, which, frankly, is newspeak for addiction: 1) The company has perfected the way notifications trigger little dopamine-shots in the brain in order to get people to return to the platform over and over again. Nir Eyal describes this addictive design in the book Hooked. 2) The algorithms and the Facebook-AI also know that the best way to get people more engaged is by fueling outrage. Nothing fuels better engagement than extreme content. The reason why a relatively small Russian troll-farm could have such a significant impact on the US-elections is that they correctly understood that outrage is the fuel that drives the Facebook-algoritms.

The point I’m making is this: Although Facebook’s rhetoric may be full of storytelling on “connecting” and “creating a better, more open world”, it’s business metric drives the behaviour of the company in a different direction. To maximize “time-on-device” and “engagement” to generate as many opportunities as possible to serve ads to people, has, in reality, led Facebook, its employees, its algorithms and its Artificial Intelligence to steer on more evil KPI’s like Facebook-addiction, craving for constant social recognition and political polarization.

This brings me back to the banker. His “digital transformation with the customer at the center” eventually also steers on traditional banking-KPI’s of selling as many products and triggering as many transactions as possible. Of course, there’s nothing wrong with this. The bank needs to make a living. However, if they would also steer on real customer-centric KPI’s, I guess they would be much more successful. If they were to focus on maximizing spending power, maximizing investment capacity or capacity to loan, maximizing interest,… they would easily be able to come up with tons of new services for which their customers would never want to switch to another bank again.

Cardinal Sin 3: An inadequate understanding of the good life.

Behind all these digital transformation stories I never hear the philosophical question whether all these changes are actually meaningful. If the goal of all these digital transformation projects is to help a spoiled consumer to buy everything faster and more frictionless, then the vision they have on humanity is incredibly limited. You can read in it the fulfilment of the ultimate corporate wet dream of reducing every human to a consumer.

Today, this reductionist consumerist vision leads to two crises of epic proportion. Of course, there’s first and foremost the ecological crisis. The speed with which our consumption behaviour is exhausting the earth and its vital resources is not sustainable. Read Kate Raworth’s “Doughnut Economics” or watch her Ted-talk.

But next to this ecological crisis we are also in the middle of a more profound psychological crisis. The more gratification we can buy, the less we seem to enjoy. The more we pursue impulses and individual greed, the emptier our existence appears to become. This crisis of meaning could well become the biggest crisis of the 21st century. It is funny in that context to observe that all those “Silicon Valley”-bobos are utterly obsessed with Stoic philosophy. Because they no longer know how to enjoy, they go back to the answers formulated two millennia ago.

In his keynote, the banker does not say a word about how the derailed banking world wants to play a meaningful role again in the lives its customers. We know what happened in 2008 with the money people entrusted to the banks. That turned out to be nothing more than casino money for speculation to increase the profits of the banks and the bonuses of the bankers. The fantastic challenges for the banks are nevertheless obvious: Helping freelancers to make ends meet. Protecting the middle class from loss of wealth and poverty in their old age (which is something the Dutch Rabobank is actively working on for example). Investing in projects that promote public prosperity. Boosting general well-being. Helping people to make their capital work for them. Looking for new ways to let the abundance of capital in the market find their way to entrepreneurs. Managing an aging population. Speeding up urbanization. Financing sustainability,…

There are so many opportunities to use digital transformation to become truly indispensable in the economy. So many possibilities to become incredibly relevant, once you put the human behind the customer at the center of your digital transformation. Simply start with replacing this spoiled persona at the heart of your transformation story with the citizen who has more and more difficulties to live a carefree life in increasingly difficult times.


Tom De Bruyne
Co-Founder SUE Amsterdam and the Behavioural Design Academy.


Cover image by April under Creative Commons License.

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