Do you remember learning about fungibility in Econ 101? It’s the idea that a good or asset can be interchanged with another similar good or asset. The part we didn’t learn about is when this is technically true, but pragmatically irrelevant.
Enter behavioral economics.
One of the first behavioral economics ideas I understood was the concept of mental accounting. Mental accounting flies in the face of fungibility. It asserts that, despite money being interchangeable, we classify our personal funds differently instead of treating each dollar as equal.
Here’s the difference between regular and mental accounting, as explained by Richard Thaler: “Regular accounting consists of numerous rules and conventions that have been codified over the years. You can look them up in a textbook. Unfortunately, there is no equivalent source on the conventions of mental accounting; we can learn about them only by observing behavior and inferring the rules.”
I initially took mental accounting to be an inherently negative thing. After all, as fungibility says: a dollar is a dollar whether it comes from my my left pocket or my right. Just another one of the many behavioral biases we succumb to as humans.
Over time, I’ve had the chance to observe actual behavior, infer the rules, and learn from personal experience.
I recently made a significant (to me) purchase, which I planned ahead for. I automatically sent money to my online savings account for months to build up what I needed. However, I commingled the money with my emergency fund, since I’m so smart and understand fungibility. Maybe somebody who hasn’t read Kahneman, Tversky, and Thaler might need to open a separate account to mentally comprehend this expense, but not me.
Well, guess what? When it was finally time to make this purchase, it felt bad. I couldn’t be more excited about what I spent the money on, and was completely prepared to do so, but the act of taking money from my emergency fund stung. I know this is technically irrational, but that knowledge doesn’t change my feelings.
Reflecting on this experience led me to something Daniel Kahneman said recently about his lifetime devotion to behavioral economics: “I’ve been studying that stuff for over 50 years and I don’t think that my intuitions have really significantly improved.”
We can know that something is “irrational”, but sometimes it doesn’t matter. We have to be cognizant of our feelings, and work around them as best we can. Mental accounting can help us as much as it can hurt us. The tricky part is being situationally aware enough to know the difference, which, as evidenced by my story, is easier said than done.
A dollar is a dollar regardless of where it comes from, but it can feel very different depending on how you frame it. Mental accounting may only be a mind trick, but who says it doesn’t matter?