Improve your decision-making. Mental accounting unveiled.

On average we make about 35,000 decisions each day.

Of course, not all decisions have the same importance and require deep thinking but 35,000 is a huge number anyway.

How can we possibly do it without feeling overwhelmed?

The answer is simple, we don’t do it. Or better we do it in a smart way!

We can handle this huge amount of decisions because we make most of them without even thinking of it, in a sort of automatic fashion. The  “automatic system” of our brain simplifies our life either switching on the “auto-pilot” mode and turning more familiar tasks into routines (no decision needed) or using simpler shortcuts to make decisions so to save our mental energy for something more important.

These shortcuts are called heuristics.

Unfortunately, heuristics are sometimes wrong. They oversimplify a problem/decision, narrowing our focus to a specific aspect only and ignoring many (and potentially important) others.

A cognitive bias, instead, is a systematic pattern that negatively influences our ability to make rational decisions. Cognitive biases are often the result of heuristics.

Heuristics and cognitive biases are only two pieces of a big puzzle but they are key to decoding and possibly improving our decision-making process.

In this post, I am going to focus on one specific cognitive bias called Mental Accounting.

If you are curious enough to keep reading, you will find an answer to the following questions:

• What is Mental accounting?
• Why do we use it and what are the consequences?
• What are the possible countermeasures?
  

What is Mental accounting?

Before getting into the crack of it, let’s look at the following scenarios:

Scenario #1.

You have just found 200 bucks on the street and there is no way to return them to the owner. You are so happy, you didn’t expect to get this money and you definitely know what to do:

• Option 1. This is a great opportunity to treat your spouse for a dinner in a fancy restaurant. You book a table right away!
• Option 2. You look at your overall situation and decide if and how to spend this money.‍

Question: Which option is closer to your way of reasoning/behaving?

Scenario #2.

You are a bit stressed about your finances and want to be more in control of your spending habits. For this reason, you set a monthly budget to track all expenses (i.e. household, leisure activities, etc.).

It is almost the end of the month and you are 200 bucks below the leisure activities budget. What do you do?

• Option 1. You don’t think twice and spend the 200 bucks enjoying your time with your friends.
• Option 2. You look at your overall situation and decide if and how you are going to spend the money.‍

Question: Which option is closer to your way of reasoning/behaving?

If you chose Option 1 at least once, I recommend you keep reading!

Definition: Mental accounting is the tendency of treating the same resource differently based on subjective criteria.

No worries…it sounds more difficult than it is!

Let’s look back at the two scenarios now.

In both cases, picking Option 1 means treating money (resource) differently based on either the income source or the intended use (subjective criteria).

If you went for Option 1, in fact, most likely you reasoned in this way:

• Scenario #1: This is extra money so I can use it for whatever I want without feeling guilty.
• Scenario #2: I still have some money left to spend on leisure activities so I can just go ahead and use it without thinking too much.

We tend to fall into the “mental accounting trap” when dealing with resources that have scarcity as a common factor: time, money, effort, etc.

My personal experience with mental accounting is related to spare time.I create mental accounts for my spare time and allocate a specific amount of time for each of them. To make it simpler, I build something similar in my mind:

• Time for exercising — x hours a week
• Time for reading — y hours a week
• Time for social activities — z hours a week.
  

Why do we use Mental Accounting and what are the consequences?

We use mental accounting because it simplifies our life in two ways:

• It gives us the feeling of being in control because it allows us to focus on one variable at a time (i.e money for leisure activities or time for exercising).
• It saves us time and energy. Assuming that we set a budget for our “leisure activities” account, as long as we are within that budget, we don’t have to go through a decision-making process every single time we feel like going to the restaurant (i.e. no need to ask ourselves if we can afford it).

Unfortunately, mental accounting is a double edge sword:

• While it gives us the feeling of being in control, it prevents us from considering our situation from a more holistic perspective.
• While it saves us time and energy, it prevents us from thinking critically about whether we are making the right decision or not.

In a few words, mental accounting narrows our focus. As a result, we base our decisions on a limited set of all available information hence we consider only a subset of all possible outcomes hence we make sub-optimal decisions.

What are the countermeasures?

If the “disease” caused by mental accounting is a narrowed focus, the best possible “cure” must be something that forces us to broaden it instead. In fact, a “rational agent” would stop using mental accounts and always consider all possible input data and evaluate all possible outcomes before deciding what is the best way to use time, money, effort, etc.

In case you, like me, don’t always behave like a rational agent, my suggestion is:‍

keep calm, think twice, and turn the autopilot off!‍

My point here is not to stop creating mental accounts but rather to stop making decisions without reflecting.

Keeping track and setting a budget for monthly expenses, for example, can definitely be ok as long as you find ways to wake your brain up before making decisions.

The following control questions can be a good “alarm”:

• Did I set the right budget (for leisure activities)? When did I last review it?
• Even if it is within the budget, am I paying a reasonable price?
• Even if it is within the budget and the price is reasonable, does it make sense to spend the money this way?

This simple trick will not turn you into a rational agent but will broaden your focus for sure.