Gambler's fallacy: The lesson I learnt last Diwali

Kyon daren zindagi main kya hoga, kuch na hoga to tajurba hoga' - Javed Akhtar (tajubra = experience)

Experience is a great teacher, but the trouble is it only comes with time, and by then the mistakes have already been made.

Last Diwali I played teen patti for the first time with friends and family. I started cautiously with a Rs 100 bet. But with beginners luck at work I easily won the next few rounds and half an hour later I had won Rs 5,000 and was now worth Rs 5,100 in total, which included the Rs 100 I had started with as well.

Then egged on by my sister, I bet the entire Rs 5,100 blind, on the tenth round that we were playing. And against the luck of the draw, I lost.

I turned around wanting to look at my sister, but before I could say anything i.e. call her names she said "Don't worry bhaiyya you just lost a hundred rupees."

Now did I? Was that really the case? Or was something else at work?

Following the time tested method of when in doubt then Google, I came to realise that I had just become a victim of what behavioural economists (a section of economists who link human psychology to economics) call "mental accounting".

Richard Thaler, a pioneer in the field of Behavioural Economics and who coined the term mental accounting, defines it as "the inclination to categorise and treat money differently depending on where it comes from, where it is kept and how it is spent."

This leads to what is referred to as the gambler's fallacy, the tendency of gamblers who lose their winnings, feeling that they haven't lost anything at all. Precisely, like what my sister said.

Watch a gambler who is lucky enough to win some money early in the evening. You might see him take the money he has won and put it into one pocket and put the money he brought with him to gamble into a different pocket. Image by Rishu83/Flickr ( Creative commons)

Thaler along with Cass Sunstein explains this in his book Nudge - Improving Decisions About Health, Wealth and Happiness. "You can also see mental accounting in action at the casino. Watch a gambler who is lucky enough to win some money early in the evening. You might see him take the money he has won and put it into one pocket and put the money he brought with him to gamble that evening (yet another mental account) into a different pocket," write the authors.

The gamblers call their winnings 'house money'. As the authors write "The money that has recently been won is called 'house money' because in the gambling parlance the casino is referred to as the house. Betting some of the money that you have just won is referred to as 'gambling with the house's money'; as if it was, somehow, different from some other kind of money. Experimental evidence reveals that people are more willing to gamble with money that they consider house money."

The house money effect is even seen at work when stock markets are on an upside. Thaler and Sunstein, give the example of the late 1990s when the world was seeing the dotcom bubble.

"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 last few years," they write.

It isn't only while gambling and investing in stock markets that human beings categorise money in different ways. As John Allen Paulos writes in A Mathematician Plays the Stock Market "People who lose a $100 ticket on the way to a concert, for example, are less likely to buy a new one than are people who lose $100 in cash on their way to buy the ticket. Even though amounts are the same in the two scenarios, people in the former one tend to think $200 is too large an expenditure from their entertainment account and so don't buy a new ticket, while people in the latter tend of assign $100 to their entertainment account and $100 to their "unfortunate loss" account and buy the ticket."

Or sample this situation. Let's say you are at an electronics shop looking to buy a laptop. You finally decide to buy a model which costs around Rs 36,300. Just as you are paying for it a friend calls and tells you about a better deal on a website which is offering the same model for Rs 36,000? Will you stop the purchase and go back home and order the laptop from the website? The chances are no.

But consider another situation where you are out looking to buy a DVD player. You finally zero down on a model that costs Rs 3,000. At that point of time a friend calls and tells you that the same thing is available on a website for Rs 2,700. Will you stop the purchase and go back home and order the DVD player from the website? The answer is yes.

The funny thing is that in both the cases you would have saved Rs 300. But in one case you decided to go ahead with the transaction and in another case you did not? Why does this happen? At a fundamental level the Rs 300 we save is being categorised into different mental accounts because we are thinking in terms of percentages. Rs 300 expressed as a percentage of Rs 36,300 is very small whereas Rs 300 expressed as a percentage of Rs 3,000 is significantly larger.

This tendency to categorise money into different mental accounts leads to several other interesting situations. Money that comes in rather unexpectedly, like a tax refund, a salary arrear, a higher than expected bonus at the end of the year, or a generous cash gift from a visiting relative for that matter, gets spent faster.

As Gary Belsky and Thomas Gilovich point out in their book Why Smart People Make Big Money Mistakes and How to Correct Them "Consider tax refunds, for example. Many people categorise such payments from the government as found money - and spend it accordingly - even though a refund is nothing more than a deferred payment of salary. Forced savings, if you will. If, on the other hand, those same people had taken that money out of their paycheck during the course of the previous year ...they would most likely think long and hard before spending it on a new suit or Jacuzzi."

This also leads to a situation where people have personal loans or huge credit card balances outstanding even though they have money lying in the bank earning nterest in the savings account or in the form of a fixed deposit. This despite the fact that the interest earned on a fixed deposit is much lower than the interest being paid on a personal loan or credit card balance outstanding.

In fact research has been carried out to show precisely this. "David Gross and Nick Souleles (2002) found that the typical household in the sample of Americans had more than $5,000 in liquid assets (typically in savings accounts earning less than 5% per year) and nearly $3,000 in credit card balances, carrying a typical interest rate of 18% or more," write Thaler and Sunstein.

Now wouldn't it have been much simpler to pay off the credit card debt instead of paying such a high rate of interest on it?

But mental accounting is at work. People put the loan outstanding into the loan mental account whereas money in the bank gets categorised as a savings mental account. And the two do not meet. As the Thaler and Sunstein write, "Many of these households have borrowed up to the limits that their credit cards set. They may realise that if they paid off the credit card debt from the savings account, they would soon run up the cards to their limits once again. (And credit card companies, fully aware of this, are often more than willing to extend more credit to those who reached the limit, as long as they aren't yet falling behind on interest payments."

Hence it is important to remember that money is fungible. So there is no point in having money lying in a fixed deposit while you are still paying off your credit card balance or a personal loan for that matter. The interest you earn on your fixed deposit will be always lower than the interest you pay on your credit card debt or on a personal loan. Given this it makes more sense to first and foremost pay off your debts instead of saving money while categorising it into a "mental account".

If all this wasn't enough, have you ever wondered why shops and malls actually accept payments made through credit and debit cards, even though they do not get the full price on those transactions? Well the answer again comes back to mental accounting.

As Belsky and Gilovich point out, "In fact, credit cards...are almost by definition mental accounts, and dangerous ones at that. Credit card dollars are cheapened because there is seemingly no loss at the moment at the purchase, at least on a visceral level. Think of it this way: If you have $100 cash in your pocket and you pay $50 for a toaster, you experience the purchase as cutting your pocket money in half. If you charge that toaster though, you don't experience the same loss of buying power that your wallet of $50 brings."

Given this, while shopping most individuals end up paying more when they use their credit cards. And that explains why shops accept credit cards happily even though they get paid only around 98% of the price of what is purchased. But they benefit because the size of the purchase goes up.

If you still haven't understood what mental accounting is all about here is a brilliant example that Thaler and Sunstein talk about.

"The concept is beautifully illustrated by an exchange between Gene Hackman and Dustin Hoffman. Hackman and Hoffman were friends back in their starving artist days, and Hackman tells the story of visiting Hoffman's apartment and having his host ask him for a loan. Hackman agreed to the loan, but then they went into Hoffman's kitchen, where several mason jars were lined up on the counter each containing money. One jar was labelled 'rent,' another 'utilities,' and so forth. Hackman asked why, if Hoffman had so much money in jars, he could possibly need a loan, whereupon Hoffman pointed to the food jar, which was empty."

Vivek Kaul is a writer and can be reached at vivek.kaul@gmail.com