Psychology, Financial Decision-Making, and Household Management

Psychology, Financial Decision-Making, and Household Management

Reason for Selecting Subject

The reason I chose this subject is that in the recent times, the aspect of financial education and understanding has become a contentious and significant one. Its importance has been realized largely because there is increasing intricacy of financial products and also the increasing accountability and liability of people with respect to their own financial well-being. It is imperative to note that knowledgeable, financially educated customers are more capable of making proper decisions for their households and as a result are better suited to enhance their economic and financial security and welfare (Hilgert and Hogarth, 2003). What is more, in accordance to behavioral economics, psychology plays a significant role in the financial and economic decisions made within the household. For instance, consumers with a great amount of money will spend less as compared to consumers with smaller amounts. The same case applies to individuals that spend more money in a current account as compared to money in a savings account. Therefore, this proposal will focus on different financial management activities within the household such as saving, spending, investment in relation to mental budgeting and accounting.

Articles Selected and Reason Thereto

1. Cheema, A., & Soman, D. (2006). Malleable mental accounting: The effect of flexibility on the justification of attractive spending and consumption decisions. Journal of Consumer Psychology, 16(1), 33-44.

Mental accounts are deemed to be components for self-control, which are utilized by consumers in order to preclude any excessive consumption or spending. This particular article is chosen to advance the article by Antonides et al. (2011) and to indicate that under particular circumstances of uncertainty, the process of mental accounting becomes malleable. This is in the sense that consumers are flexible in allocating expenses to various mental accounts. The article points out the manner in which consumers flexibly categorize expenses, or create accounts in order to rationalize spending. In particular, an expense that can be allocated to more than one account has a greater likelihood of being incurred compared to an unambiguous expense that is inhibited either by prevailing budgets or by previously created accounts. Furthermore, the article delves into the justification practices that motivate these outcomes and their inferences for mental accounts as self-discipline devices. This article is meant to aid in expounding the financial slackness through the malleability of mental accounts and how consumers can easily side-step the rules enforced.

2. Heath, C., & Soll, J. B. (1996). Mental budgeting and consumer decisions. Journal of consumer research, 23(1), 40-52.

This article has been chosen because it discusses mental budgeting at length. As delineated in the article, usually, consumers set budgets for categories of expenses and go on to track them against the budget they have set. Taking into account that budgets are not able to expect consumption prospects precisely, individuals might earmark excessive money or lesser money for a certain category. In particular, this causes the consumers to under consume or overconsume products in that particular category. For instance, the article shows that consumers set budgets that amount to under consumption. In addition, to demonstrate that consumers track their expenses and costs, the article outlines that budgeting effects are greater for buys that are largely characteristic of their category. These buys reduce the amount consumers spend in a category and hinders the ability to buy other typical products.

Expounding Articles

In expounding the two articles, what is suggested is an additional independent variable, which is an ambiguity expense. The inclusion of this variable is purposed to perceive whether the consumers will be able to bypass the rules set up within mental accounting and how they are able to purchase the products they had initially out to avoid.

Theoretical Background

The issue of consumer self-discipline and restraint has been in practice for a long time. The necessity to carry out self-discipline emanates from a battle between the immediate and longstanding consequences of consumption. This restraint establishes itself as an impulse contention that has to be overcome by experiencing a mental cost to break predetermined rules, for instance using pension money for going on vacation.

Mental accounting, which is different from economic accounting in the sense that the labeling of money is done for certain spending or saving categories, and the budgets earmarked for spending or saving are deemed compulsory. This particular aspect influences the financial behavior of households. To begin with, labeling money for certain spending categories might result in overspending and underspending. For instance, if the budget is higher, then there is a likelihood of high spending and vice versa. Therefore, mental budgeting helps evade undesirable balanced within certain mental budgets.

Mental budgeting goes in tandem with information on mental accounting, which shows that individuals utilize resources in a different manner depending on how they are labeled. The setting of budgets causes individuals to overconsume a number of products while under consuming others. Taking into consideration that budgets are established prior to consumption opportunities and chances that come about, at times they underestimate or overestimate the cash required or an exact account. In addition, the practice of tracking expenses means that a number of expenses are more likely to bring about overconsumption or under consumption. The more consumers track their costs, expenses that are comparatively simple to categorize end up being the most susceptible to the rigidities of budgeting.

Mental accounts function as self-controlling tools in two distinctive manners. To begin with, the role they play in terms of budgeting take into account assigning and coding of incomes, outlays, and activities to particular accounts. Costs and expenditures are split into different spending categories and the level of spending in every category is limited by budgets. In particular, this takes into account earmarking an exact amount of money for a category of expenses and allocating incurred costs from that category to the chosen and labelled mental account. By playing this particular role through the tracking of expenses in accounts, the budget functions as a toll on aberrant behavior and hinders consumers from overspending on products that they desire to purchase but should not.

Secondly, accounts that are specific to transactions enable consumers to institute a mental account for a transaction, make a debit for the transaction payments, and thereafter credit the mental account with the benefit attained from consumption. Being able to track these expenses and gains, aids the consumer to close the account with a general gain. These sorts of accounts make certain that consumers do not waste an advance payment by foregoing consumption in support of a more striking alternate consumption prospect. In a perfect state, mental accounts could function as inflexible self-discipline tools. This implies that they hinder and restrict consumers from undertaking what they wish to do, and instead forcing them to undertaken what they perceive they ought to do.

Uncertainty in the process of mental accounting presents consumers with prospects to take part in inventive bookkeeping. This enables them to evade established controls and in turn engage in the particular behavior being avoided in the first place. For instance, if one limits himself to one burger a day, then the consumer can choose to have a bigger burger each day. Despite the fact that mental accounts are major components for self-control, they are also more often than not, weak. The aspect of malleability in mental accounting takes into consideration the consumer being flexible in categorizing ambiguous expenses or in creating mental accounts to accommodate uncategorized expenses. In particular, this element of flexibility enables consumers to discover ambiguities and to by-pass the self-discipline enforced by mental accounts.

Hypothesis

H0: Construction of accounts subsequent to considering the ambiguous expense increases level of spending.

H1: Construction of accounts subsequent to considering the ambiguous expense does not increase level of spending.

Actions to be done

The proposal encompasses a survey of participants, irrespective of age or gender. The participants will be required to construct accounts before and after consideration of the expenses. Subsequent to learning about a potential cost they are bound to incur, the participants will be requested to outline whether to incur such expenses before or after, and assign such expenses to categories.

Order 2: Summary

Antonides, G., de Groot, I. M., van Raaij, W. F. (2011). Mental Budgeting and the Management of Household Finance. Journal of Economic Psychology, 32: 546-555.

Abstract

The article examines both mental budgeting and financial management in a large sample of Dutch population. Results obtained showed that mental budgeting was relatively common, and it was largely outlined through different aspects such as financial understanding, general knowledge, having objectives for saving, time positioning, and financial state of affairs. Secondly, the results showed that mental budgeting, together with the impact of financial circumstances, time orientation and financial understanding, was positively correlated to having a general idea of expenses and current accounts, and household financial management.

Introduction

In delineation, mental accounting takes into account the aspect of mentally setting apart different economic classifications or groupings. For instance, an individual may mentally separate finances for clothing, food, clothing and miscellaneous activities for a certain period, such as a month. It is important to take note that mental budgets are associated and linked to the end goal of money, whether it is being spent or being saved. However, they can be associated to the basis of money, for instance as compensation, inheritance or grant.

Mental Accounting

Aspects of Mental Accounting

There are several different aspects of mental accounting theory, all of which are centered on the psychological distinctions of economic classifications, but do not essentially encompass mental budgeting. They consist of hedonic editing, categorization of gains and losses, earmarking and labeling of income and assets, simultaneous borrowing and saving, and mental budgeting. To begin with, hedonic editing also referred to as 'hedonic framing' takes into account assessing the combinations of gains and losses as experienced by people. Research has shown that people have a preference to segregation of gains over integration and also have a preference for the integration of losses over segregation. Nonetheless, research has shown that individuals follow these rules only if the gains and losses took place at different times.

The second aspect is the categorization of gains and losses and it is outlined that the typical categorization of items enhances the probability of classification in a certain grouping. The element of categorization is significant because it is a determining factor as to whether or not a certain category budget will be deemed worn-out and washed out. Third, there is earmarking and labeling of income and assets. Labeling is essential because it impacts how income payments influence consumer spending. Income labelled as belonging to either a current, asset or future income account is linked with various marginal propensities to consume. For instance, current account results in high consumption whereas, future income in comparatively low consumption. Money labelled as income will probably be spent more compared to a huge amount of income labelled as belonging to the asset account.

Another aspect is mental accounting, which is different from economic accounting in the sense that the labeling of money is done for certain spending or saving categories, and the budgets earmarked for spending or saving are deemed compulsory. This particular aspect influences the financial behavior of households. To begin with, labeling money for certain spending categories might result in overspending and underspending. For instance, if the budget is higher then there is a likelihood of high spending and vice versa. Therefore, mental budgeting evades undesirable balanced within certain mental budgets. In addition, the income labels for saving or spending might explain the debt-puzzle. This encompasses the element of several individuals borrowing money at the same time at relatively high rates of interests and saving money at rates of interest that are considerably lower. Other aspects of mental accounting that are taken into consideration consist of the issue of transaction versus acquisition utility, payment decoupling, the sunk cost phenomenon, and choice bracketing.

Correlates of Mental Budgeting

The assumption made in the article is that mental budgeting is practiced with the purpose of maintaining control of household finance, particularly when there are restricted financial means. Therefore, the need for mental budgeting becomes lower and practiced when more money is accessible within the household. Therefore, it is anticipated that households with higher income undertake less mental budgeting. However, as debt level increases, consumers will partake in more mental budgeting. In the same manner, greater age implies more experience and therefore minimal mental budgeting. This is assumed because consumers or individuals might have learned and attained knowledge on how to cope with money and avoid using mental budgets.

Results

The research analysis focused on mental budgeting with respect to its impact on two elements, which are financial management and having an overview of expenses. Table 3 is indicative of the results of both the initial stage regression of mental budgeting, comprising the estimations for the instruments, and the instrumental variables regression on the dependent variable. As shown, higher education has an adverse impact on mental budgeting in comparison to intermediate as well as low education. On the other hand, having saving goals has a constructive impact. In accordance to the statistical F-test, instrument variables have a partial impact that is significant and substantial. This is different from Sargan's test, which is not significant and shows no correlation of the instruments and the error terms of the regression equation. The variables that have a negative and adverse impact on mental budgeting include being male, savings, net household income, short-term time orientation, and net home equity. On the other hand, the variables that have a positive and constructive impact on mental budgeting include the knowledge and understanding of financial products and investments, debt amounts, and long-standing time orientation.

Table 4 indicates the similar initial stage mental budgeting regression as illustrated on the preceding table. There is no significance with respect to Sargan's test, which implies that the instruments are not correlated to the error terms of the financial management regression. In accordance to the Wu-Hausman test, we reject the null hypothesis, which is indicative of the suitability of the instrumental variables method. Considering this, it can be perceived that mental budgeting through the instrumental approach has a positive impact on the dependent variable that is financial management. On one hand, the amount of savings as well as the net home equity positively affect financial management, whereas debts have an adversely impact. Other variables such as religion, age, and also being Dutch have a constructive impact on financial management. What is more, financial management is influenced positively by long-term orientation, while short-term influences it negatively. Lastly, having financial knowledge and understanding of financial products have a positively impact whereas the lack thereof has a negative impact.

Conclusion

Mental budgeting seems to be extensively practiced in the Netherlands and numerous preceding findings in the literature regarding the determining factors of mental budgeting are reproduced. One of the inferences made is that higher education is linked with lower mental budgeting in comparison to intermediate and lowers education. This is largely because it stirs more analytical thinking. Secondly, having saved goals is linked with additional mental budgeting for the reason that objectives for saving bring about labels for mental accounts and therefore enabling mental budgeting. Third, on one hand, long-term time orientation positively influences mental budgeting whereas short-term time orientation has an adverse impact. Knowledge of financial products and investments has a constructive impact on mental budgeting, which indicative of the aspect that it is not a simple kind of financial management. Another inference is that the financial status of the household also has an impact on mental budgeting. Wealthy households have a less likelihood of practicing mental budgeting compared to less wealthy households. In addition, male consumers have a lower tendency of utilizing mental budgeting compared to female consumers. This particular result goes in tandem with indicating that gender is not associated with mental partialities, except for instances of risky decision-making. What is more, mental budgeting has a substantial influence on having a general idea of expenditures and current accounts, because expenses necessitate tracking against the set budgets. Being religious adversely affects overview but is positively linked with financial management.

References

Antonides, G., de Groot, I. M., van Raaij, W. F. (2011). Mental Budgeting and the Management of Household Finance. Journal of Economic Psychology, 32: 546-555.

Hilgert, M. A., Hogarth, J. A. (2003). Household Financial Management: The Connection between Knowledge and Behavior. Hein Online.