Home / Money / Personal Finance /  Mental account lessons from Dustin Hoffman

Decades ago, when Gene Hackman and Dustin Hoffman were struggling actors, Hackman visited Hoffman’s home and Hoffman asked him for a loan. Hackman agreed to give the loan.

After this, Hackman went into his host’s kitchen only to find various mason jars labelled as rent and entertainment and so on stuffed with some money in them. Of course, Hackman asked Hoffman, if there was money in the jars, why did he need a loan? To which, Hoffman explained that the food jar was empty.

This is a story that Richard Thaler and Cass Sunstein write about in their new book Nudge: The Final Edition. While this might sound like many of those film anecdotes that come out once the actors become successful, it has serious personal finance lessons in it.

Money is fungible. It doesn’t distinguish between being stored in the rent jar or the food jar. If Hoffman had had $20 in the rent jar, it would have bought him $20 worth of food as well. So, Hoffman wasn’t really short of money to buy food. Just that he had divided the money he had into different mental accounts in his head, which led to him asking for a loan from his friend Hackman.

The interesting thing is that almost all of us indulge in a bit of mental accounting. Take the case of a tax refund. People tend to categorize it as found money in their mind and then spend it freely, like they have just received a windfall.

As Thaler and Sunstein write: “People are far more likely to splurge impulsively on a big luxury purchase when they receive an unexpected windfall than they are with savings that they have accumulated over time."

But if you think about it, a tax refund is also your income. It’s just that it was stuck with the government and the government took its time giving it back to you. Hence, it needs to be treated in the same way as regular income.

Then there are cases of people having outstanding credit card debt and a lot of money in their savings account earning an interest of 3-4%, at the same time. This is because credit card debt goes into the loan ‘mental’ account and money in the savings account goes into the savings ‘mental’ account. This leads to a situation where people end up paying a huge amount of interest on credit card debt while earning an interest of 3-4% on savings accounts.

As Thaler writes in Misbehaving: The Making of Behavioural Economics: “Money is fungible, meaning that it has no labels restricting what it can be spent on... The failure to treat various pots of money as fungible... is what makes... [mental] accounting... feasible."

Insurance companies also play on this by selling different investment plans to save for children and for retirement. Ultimately, one needs to save and that is the most important part, but people have different savings mental accounts in their heads and insurance companies capitalize on that.

Thaler and Sunstein talk about the dotcom bubble of the 1990s and the real estate bubble of the 2000s in the US, and how mental accounting contributed to it. As they write: “Mental accounting contributed to the large increase in stock prices in the 1990s, as many people took on more and more risk with the justification that they were playing only with their gains from the past few years. The same thing happened with speculative real estate investors a few years later."

In fact, it is safe to say that the same thing is happening in the stock market in India and other parts of the world right now, with people increasingly taking on more and more risk with having categorized their gains into a separate mental account.

To conclude, mental accounting is something that we need to be aware of when it comes to managing our hard-earned money and then ensure that we don’t make the basic mistakes that we end up making because of it.

Vivek Kaul is the author of Bad Money.

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