What Is Mental Accounting?

What Is Mental Accounting?

Let me explain mental accounting to you—it's a key idea in behavioral economics that I think you need to grasp. It describes how you and I might assign different values to the same amount of money based on subjective criteria, which often leads us to make irrational decisions.

This concept was developed by economist Richard H. Thaler, and it shows that we classify funds in various ways, making us prone to poor choices in spending and investing.

Key Takeaways

Remember, mental accounting is that behavioral economics notion from Nobel Prize winner Richard Thaler, where people like you and me place varying values on money. It frequently causes us to make irrational investment calls and act in ways that harm our finances, such as keeping money in a low-interest savings account while juggling big credit card debts.

To steer clear of this mental accounting bias, treat your money as fully interchangeable, no matter if it's in a budget for daily expenses, a fun spending account, or an investment for building wealth.

Understanding Mental Accounting

In his 1999 paper 'Mental Accounting Matters,' Richard Thaler, who teaches economics at the University of Chicago Booth School of Business, defined mental accounting as the cognitive processes we use to organize, evaluate, and track our financial activities.

At the core of this is the fungibility of money—meaning all money is the same, no matter where it comes from or what you plan to do with it. To avoid the bias, you should treat money as perfectly fungible when allocating it across accounts. Value every dollar equally, whether you earned it through work or received it as a gift.

Thaler noted that people often break this fungibility rule, especially with windfalls. Consider a tax refund: you might see it as 'found money' and spend it on something extra, but it's actually your own money being returned, not a gift. Treat it like your regular income, not something for splurging.

Important Note on Avoiding Bias

To dodge mental accounting bias, value every dollar the same way—whether it's from your job or handed to you. Don't view a tax refund as a windfall for frivolous spending.

Example of Mental Accounting

This way of thinking in mental accounting might seem logical at first, but it's actually highly illogical. For example, some people set aside a special 'money jar' for a vacation or new home while carrying significant credit card debt. They treat the jar money differently from what's needed for debt, even though shifting it to pay off debt would cut interest costs and boost net worth.

Breaking it down, it's detrimental to keep a savings jar with little or no interest while your credit card debt racks up double-digit interest. That debt interest will wipe out any savings gains. You'd be better off using those saved funds to clear the expensive debt before it grows.

The fix is simple, yet many don't do it because of the personal value they attach to certain funds. People often think money for a house or child's education is 'too important' to touch, even if it's the smartest move. That's why keeping money in low-interest accounts while holding debt is so common.

Fast Fact

Professor Thaler appeared in the movie 'The Big Short' to explain the 'hot hand fallacy' related to synthetic CDOs during the housing bubble before the 2007-2008 financial crisis.

Mental Accounting in Investing

You see mental accounting bias in investing too. Many investors split their assets into safe and speculative portfolios, thinking it protects the total from negative speculative returns.

But the net wealth difference is zero whether you have multiple portfolios or one big one. The only real difference is the extra effort to keep them separate.

Drawing from Daniel Kahneman and Amos Tversky's loss aversion theory, Thaler gives this example: Suppose you own two stocks—one with a paper gain, one with a loss—and need cash, so you sell one. Mental accounting pushes you to sell the winner, even though selling the loser makes more sense for tax benefits and because it's a weaker holding. The pain of locking in a loss is too great, so you avoid it—this loss-aversion effect misguides your decisions.

Why Do We Do Mental Accounting?

We naturally treat money differently based on its origin and intended use. This approach might feel right, but the more you examine it, the less sense it makes, and it can harm our finances.

Is Mental Accounting a Behavioral Bias?

Yes, it's a behavioral bias—those irrational beliefs or actions that unconsciously affect our decisions, leading to illogical ways of handling money.

How Can Mental Accounting be Prevented?

The key is to treat all money as interchangeable and avoid labeling it. Don't see certain money as less important just because it's from an unexpected source, and don't leave funds in low-interest savings when you have high-cost debts to pay off.

The Bottom Line

Mental accounting is a pitfall that catches many of us, even experienced investors. We assign subjective values to money based on its source and purpose, which might seem reasonable but often leaves us worse off financially.