What is mental accounting?

The term “mental accounting” describes the various valuations individuals assign to the same amount of money based on arbitrary standards, frequently leading to unfavorable outcomes. An idea in the study of behavioral economics is called mental accounting. The theory, which economist Richard H. Thaler developed, holds that people make irrational spending and investing decisions because they have diverse ways of classifying funds.

Comprehending Mental Accounting

Richard Thaler, an economics professor at the University of Chicago Booth School of Business, defined mental accounting as “the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities” in his 1999 paper “Mental Accounting Matters. The idea that money is fungible forms the basis of the theory. Money is said to be fungible if it is the same regardless of where it comes from or what it is meant to be used for.

When distributing money among several accounts, such as a wealth account (savings and investments), a budget account (daily living expenditures), or a discretionary spending account, people should perceive money as fungible to avoid mental accounting bias. They ought to respect money equally, regardless of whether it is handed to them or acquired via labor. According to Thaler, people routinely break the fungibility principle, especially when they are receiving a windfall. Get your tax refund. Receiving a check from the IRS is typically seen as “found money,” or extra money that can be used for any discretionary purpose. However, as the term “refund” suggests, the funds belonged to the individual in the first place and are essentially a return of funds (in this example, an overpayment of taxes), not a gift. Consequently, it should not be regarded as a gift but rather as the person would regard their monthly salary.

An illustration of mental accounting

The mental-accounting school of thought is highly irrational, even though it makes sense on the surface. For example, some people carry a significant amount of credit card debt and have a specific “money jar” or equivalent fund for a new home or trip. Even if taking money out of the debt repayment process results in higher interest payments, which lowers their overall net worth, they will probably regard the money in this particular fund differently than the money used to pay down debt.

To put it another way, it makes no sense that it can be harmful to have credit card debt accruing double-digit interest each year and hold a savings jar that yields little to no return. The interest accrued on this loan will often offset any potential interest gains from a savings account. In this case, it would be preferable for the individuals to use the money they have saved in the particular account to settle the costly debt before it grows.

Although there seems to be an easy fix, many people do not act this way. The rationale is related to the kind of personal value that people attach to specific possessions. For instance, many believe that savings for a new home or a child’s college fund are just “too important” to give up, even when doing so would be the most sensible and advantageous course of action. Thus, it’s still usual to keep money in a low-interest or no-interest account while still having outstanding debt.

When Investing, Mental Accounting

People also frequently suffer from mental accounting bias when it comes to investing. Many investors allocate a portion of their assets between safe and risky portfolios to mitigate the risk of speculative investments negatively affecting the whole portfolio.

Whether the investor has one more extensive portfolio or several smaller ones makes no difference in net worth in this scenario. The investor’s time and effort in separating the portfolios from one another is the only difference between these two scenarios.

Investors frequently make illogical decisions as a result of mental accounting. Thaler provides the following illustration using the ground-breaking loss aversion theory that Daniel Kahneman and Amos Tversky developed:

An investor owns two shares of stock; one has a paper gain and the other a paper loss. The investor must sell one of the stocks to raise money. Because selling the losing stock is a poorer investment and tax-loss benefits are associated with it, mental accounting favors selling the winner, even if selling the loser is typically the most logical course of action. The investor sells the prize to escape the agony of incurring a loss since it is too much for them to handle. This is the loss-aversion impact that has the potential to mislead investors about their choices.

Why Do We Compute Mental Equilibrium?

Individuals naturally treat money differently based on various criteria, including where and how it is received. The more you consider it, the less sense that kind of thinking makes, and in the end, it hurts our wallets.

Is there a behavioral bias in mental accounting?

Indeed. Irrational thoughts or actions that unintentionally affect our decision-making are behavioral biases. Furthermore, it might be said that mental accounting leads to erroneous perspectives on and approaches to money management.

What are the ways to prevent mental accounting?

Treating money as interchangeable and refusing to assign it labels is the key to overcoming mental accounting and not giving in to it. Don’t write off money from an unexpected source or keep putting money in a savings account that earns very little interest when you have debts to pay back that require significantly higher borrowing rates.

The Final Word

Mental accounting is a mistake that many people, even seasoned investors, make frequently. Most people assign money a subjective value that primarily depends on its source and intended purpose. Even if that strategy seemed innocent and perfectly fair, it might backfire and hurt our financial situation.

Conclusion

• Richard Thaler, the Nobel Prize-winning economist, developed the idea of “mental accounting,” which is the different values people have for money based on their preferences.
• People who do a lot of mental accounting often make bad investment choices and act in ways that hurt their finances, like putting money into a savings account with low interest while still having big credit card bills.
• People should treat money as completely replaceable, no matter where they put it, whether in a wealth account (for savings and investments) or a budget account (for everyday living costs). This will help them avoid the mental-accounting bias.