More mental accounting forms: the “endowment effect” and “nudge theory”

by J. Money -

plasma brain

So I found out there’s a term for what we were talking about the other day on treating your money differently depending on how you get it!

It’s called “mental accounting” and apparently is a pretty popular thing, based on work by Nobel Prize recipient, Richard Thaler :) Here’s a description of it from Investopedia:

Mental accounting refers to the tendency people have to separate their money into different accounts based on miscellaneous subjective criteria, including the source of the money and the intended use for each account.

That about sums it up! Haha… Although not sure about the 2nd part of the explanation:

The theory of mental accounting suggests that individuals are likely to assign different functions to each asset group in this case, the result of which can be an irrational and detrimental set of behaviors.

I will admit to the irrational part of treating your “extra” money differently since money is still money no matter where it comes from!, however is it really that detrimental to your financial well being?! I don’t think so, at least in my particular case… I think you get into much more trouble when you’re playing around with your “core” income than your side pots. But who am I to postulate – I’m no Nobel Prize winner ;)

Still – pretty neat there’s a TERM for it! Thanks to everyone who let me know about it, particularly Shannon who then sent over this fantastic article on all the ways mental accounting can affect us:

Four things Richard Thaler taught us about irrational behaviour

The first two we’ve already covered (#1. was a breakdown of what “mental accounting” is – i.e. the way we process money differently, and #2. was around “house money” – when you tend to be more risky with winnings because it feels more like someone else’s money), but here are examples #3 and #4 which I found equally as fascinating (and guilty of as well!):

#3. The “endowment effect” — The idea that we tend to overvalue what we own simply because we have it! “Thaler demonstrated the effect in action in a classic experiment in the 1980s while working at Cornell University in the US. He randomly handed out free coffee mugs to students and asked those who had received mugs how much they would sell them for, and those who hadn’t how much they would pay for them. The typical recipient of the mug demanded $4.75 but the typical buyer offered $2.25. The mere possession of the mug—which in this case was accidental—caused people to value it highly.”

I catch myself doing this alllll the time with new coins I add to my collection, haha… As soon as it’s in my possession it feels as if they’re 10x as valuable! Especially the *longer* it’s in my possession for :) I always thought it was maybe due to me being able to appreciate them more as you have more time to look at them/research them, but I suppose that doesn’t hold the same weight for non collectible things like mugs, etc…

Same goes for anything *sentimental* too. I always perceive the items that have attached memories to be much more valuable than the actual items themselves, which of course is nonsense and why so many of us can’t ever get rid of our stuff! (Or price them too high when we try – hah!)

#4. The “nudge theory” — This is one of my favorites, and something I wish became more mandatory across our country. “Thaler’s nudge theory is especially relevant to retirement planning. Research shows that when employees are automatically enrolled (given a “nudge”) into a retirement plan (with the option to withdraw), far more people sign up than would have if they had to enroll themselves.”

YES!!! Because people are lazy!!! Even with things that they say are important to them! So you always have to find ways to use this to your advantage, and “forcing” them to automatically enroll in things is exactly the key to ramp up savings… (though of course the same trick works in opposite ways too, like signing up to subscription services that you’re then too lazy to cancel later!)

Thaler also co-designed something called the “Save More Tomorrow” plan (SMT), in which people commit to saving more later, but actually opt into the plan *now*.

As Thaler explains, “self-control is easier to accept if delayed rather than immediate.” And, as planned increases are linked to pay raises, it is meant to diminish the effect of loss aversion – the tendency to feel losses larger than gains.

So basically people signed up for this “Save More Tomorrow” plan early on, and then later when they got their raises a portion of it was automatically siphoned away into savings and they didn’t even notice it. Because they didn’t even have a *chance* to notice it! Haha… The first go at it was so successful – quadrupling employees’ savings rates from 3.5% to 13.6%!! – that it got disseminated around and is now apparently used by millions of people. I guess internationally, since we sure don’t have this here?!

Anyways, all this to prove yet again that emotions are very much a part of our finances, and can be used to help AMP them or DESTROY them depending on how they’re harnessed :)

Personally I try using my energy to AMP it, but Lord knows there are times where I might as well have just lit my cash on fire! Haha… But we live and we learn! And the more we continue learning about *ourselves* in particular, the better we’ll recognize when this “mental accounting” is in play.

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{ 21 comments… read them below or add one }

1 Jacq March 28, 2019 at 7:14 am

I belive they also studied the ‘nudge theory’ internationally related to organ donation selection on a driving license (or something similar). People may opt out, but are less likely to do so.
My 401k plan has the default set to a 1% increase in contribution annually automatically. I opted out because I’m closer to maxing out (plus side hustle solo 401k), so I need to make sure things don’t go over. I don’t think I’ve heard anyone else at work mention it, so I’m guessing it works.

Thanks for sharing the new information you got!

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2 J. Money March 28, 2019 at 9:46 am

Thanks for sharing yours on the organ donating! I wonder how many other areas of life you could actually apply this too?

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3 Your Money Blueprint March 29, 2019 at 3:46 am

The nudge theory – email subscribers to Budgetsaresexy.com :)

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4 J. Money March 29, 2019 at 1:54 pm

Haha… I like the way you think ;)

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5 Tracy March 28, 2019 at 8:02 am

My old job allowed for people to enroll in an automatic 1% increase of their 401(K) once a year but capped out at 15%. Since I was already investing greater than 15% it didn’t do me any good. And our contacts weren’t able to explain to me why it got capped there when, for most of us, that would be nowhere close to maxing out so yay for trying and boo for not making it very effective?

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6 J. Money March 28, 2019 at 9:48 am

that is strange? maybe it’s to protect people from “going too much over”, which of course would actually be a good thing? ;) At least give y’all the option to “opt into” higher levels!

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7 Christine March 28, 2019 at 8:13 am

I think I selected a plan that gradually increases my contribution to my retirement plan…see, this proves the theory. I can’t even remember!

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8 J. Money March 28, 2019 at 9:49 am

Haha… you should log into it one day and see how much you’ve accumulated over all these years of forgetting :)

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9 Joe March 28, 2019 at 10:02 am

Ugh! I’m really feeling the endowment effect right now. We’re trying to sell our old condo and it’s taking longer than I’d like. We might have to lower the price. :(

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10 J. Money March 28, 2019 at 2:44 pm

That blows, I’m sorry :(

Maybe you can lower it enough where you might get a couple of people fighting over it?? Some of the homes I’m looking at for our move are being sold within HOURS with multiple offers coming in – and are all priced either dead on or lower to drum up the excitement… (except for the buyers who then have to compete!)

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11 Erica March 28, 2019 at 11:34 am

I’ve been doing the “save more tomorrow” thing with my husband and I’s raises for years. Now I have a name for it! It works really well, since you can’t miss something you never had. I learned about it from a neighbor years ago, who always said she planned on retiring at age 40, and just a few months ago, she did just that :-)

First comment after lurking for about a year. Love this blog!

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12 J. Money March 28, 2019 at 2:45 pm

HEYYY COOL!!!

On both your neighbor’s retirement and you finally stopping by to say hi to me :)

Hello! *Waves*

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13 Dana March 28, 2019 at 12:32 pm

That’s really interesting because my employer just put auto enrollment in our 401(k) at the top matching percentage this year. To not be auto enrolled you need to go to a website and decline. I’m curious how many people will bother to do that. I have a feeling participation in our 401k is going to go way up this year!

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14 J. Money March 28, 2019 at 2:46 pm

YES IT WILL!!!

That’s awesome they’re doing that!! :)

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15 Becky March 28, 2019 at 1:22 pm

I agree that “mental accounting” can be irrational and detrimental (sometimes). For example, I had a friend who had budgeted year after year and gotten around $3000 into a savings fund for emergencies. Then something happened to their car and it would need over $1000 in repairs. My friend was freaking out because she was only thinking of their monthly income and the balance in their checking account. She was nearly in tears before someone reminded her about her emergency fund and since this car repair is an emergency, that should be exactly what it is for. She still struggled with it because she doesn’t want her emergency fund to get too low but it just goes to show how different it might have been if the money was just sitting in her checking account.

On the other hand, I think it’s helpful to “separate my money in my mind.” Otherwise, I would probably have zero saved for emergencies because the total in my checking account would seem like it’s enough for a purchase here and another purchase there, until it’s gone, haha!

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16 J. Money March 28, 2019 at 2:51 pm

That emergency fund thing is totally real!!!

Even us $$ bloggers have a hard time spending it because it just looks so nice and pretty sitting there finally after years of building it up!! Who wants to spend any of it and have to re-fill again?? ;)

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17 Chadnudj March 29, 2019 at 10:10 am

As someone familiar with Chicago (at least from some pics on your site), you’ll appreciate the great example of the nudge effect on Lake Shore Drive and Oak Street, where the lines on the curve (designed to get you to slow down) are not evenly spaced but instead are put at increasingly closer distances as you approach the curve to give you the illusion of going faster (so you thus slow down even more):
https://nudges.wordpress.com/tag/traffic/

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18 Chadnudj March 29, 2019 at 10:15 am

I also will absolutely recommend Thaler/Susstein’s book Nudge, if you’re into this sort of stuff….great insight into easy ways to improve our world by turning human inertia/laziness/misperceptions to a socially optimal advantage.

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19 J. Money March 29, 2019 at 2:03 pm

Woww that is cool! Love seeing all the applications with it!

And yes to that book too – been on my list for a while and then keep forgetting about it… I think its time to finally scoop it up from the library :)

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20 Kate April 3, 2019 at 6:17 am

Oh! I love this guy! I heard him on the Freakonomics podcast and could never remember the expression “mental accounting” to read more about it. Thanks!

Here is the podcast:
http://freakonomics.com/podcast/richard-thaler/
People Aren’t Dumb. The World Is Hard. (Ep. 340)

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21 J. Money April 3, 2019 at 6:45 am

Oooooh thank you!!! That sounds like a fantastic listen!

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