One of the cognitive biases is called mental accoun– ting.
It happens because we mentally put things into categories so that we can deal with the complex world in which we live.
It simplifies things.
This is very useful in many ways, especially in controlling expenditure against separate budgets, and is commonly used in business and personal finance.
However, it can also lead us into making poor decisions because we may be blinded by the way we have defined things.
This definition of things into categories or acco‒ unts, which is, like many common heuristics, a useful way of dealing with many problems in life, can also lead us into a cognitive bias.
In mental accounting, we take things that are identical and split them into two or more mental accounts.
The result can be that, although what is in each category is identical, we now regard it differ‒ ently in our minds.
This mental accounting is very common and can be particularly pernicious in investing.
Economist Richard Thaler gives a good example of this process.
Imagine that a married couple are saving to buy a holiday home in five years’ time.
The $100,000 they have saved so far is accumulating in a savings account at 4.5 per cent interest.
Then their old car breaks down and is not repairable, so they need to buy a new one.
They finance the $25,000 cost with a loan at 9 percent.
When it is presented like this, and we are not personally and emotionally involved in the decision, we can see the apparent stupidity of this decision.
Clearly, the couple should use $25,000 of their savings, which costs them only 4.5 per cent in interest forgone, and deposit the repayments they intend to make on the car into the savings account.
If at this point you find yourself wanting to defend the decision the couple made, you are probably in denial on this cogni‒ tive bias.
The reason they do not use their savings is at least partly because they have categorised the money in the savings account as ‘holiday house money’ and the money they intended to apply from income to car repayments as ‘car money.’ However, this is enti‒ rely a mental construct.
Clearly each dollar is the same as every other dollar.