Framing Effect

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Framing Effect

One other form of mental accounting is worth noting. The framing effect addresses how a reference point, oftentimes a meaningless benchmark, can affect our decision.

How it works

Let’s assume, for example, that we decide to buy that television after all. But just before paying $500 for it, we realize it’s $100 cheaper at a store down the street. In this case, we are quite likely to make that trip down the street and buy the less expensive television. If, however, we’re buying a new set of living room furniture and the price tag is $5,000, we are unlikely to go down the street to the store selling it for $4,900. Why? Aren’t we still saving $100?

How we see it

Unfortunately, we tend to view the discount in relative, rather than absolute terms. When we were buying the television, we were saving 20% by going to the second shop, but when we were buying the living room furniture, we were saving only 2%. So it looks like $100 isn’t always worth $100 depending on the situation.

How to handle it

The best way to avoid the negative aspects of mental accounting is to concentrate on the total return of your investments, and to take care not to think of your "budget buckets" so discretely that you fail to see how some seemingly small decisions can make a big impact.