Mental accounting refers to the different values a person places on the same amount of money, based on subjective criteria, often with detrimental results. This concept, rooted in behavioral economics and developed by economist Richard H. Thaler, highlights the irrational decision-making in spending and investment behaviors due to how individuals categorize money differently.
Key Takeaways
- Mental accounting, introduced by Nobel laureate Richard Thaler, refers to the varying values people place on money based on subjective criteria.
- This bias often leads to irrational investment decisions and financially counterproductive behaviors, like funding a low-interest savings account while holding high-interest credit card debt.
- To avoid falling into the mental-accounting trap, treat every dollar as interchangeable, whether assigned to a budget, discretionary spending, or savings and investment accounts.
Understanding Mental Accounting
In his 1999 paper, “Mental Accounting Matters,” Richard Thaler defined mental accounting as “the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities.” An underlying concept is fungibility—the notion that money is interchangeable regardless of its source or intended use.
Thaler notes that people breach the fungibility principle, especially with windfalls. For example, a tax refund is often seen as “found money,” making recipients more likely to splurge, even though this money originally belonged to them. These funds should be treated as any regular income.
To combat mental-accounting bias, view all money equally regardless of its source. Refraining from mentally segregating found money as distinct from earned income is essential.
Example of Mental Accounting
Consider someone who sets aside money in a special jar for a vacation or a new home while carrying substantial credit card debt. This personal valuation makes that set-aside money feel special, unlike the funds used for paying down debt. The illogical practice results in high-interest payments on debt, reducing overall net worth.
It’s often more rational to use these savings to pay off high-interest debts. However, emotional attachment prevents many from doing so, resulting in unnecessary financial strain.
Thaler illustrates this concept in the film The Big Short, discussing the “hot hand fallacy” related to synthetic collateralized debt obligations (CDOs) prior to the 2007-2008 financial crisis.
Mental Accounting in Investing
Investors are prone to mental-accounting biases as well. Commonly, they separate assets into safe and speculative portfolios, thinking this will protect the total portfolio from negative speculative returns. However, managing multiple portfolios doesn’t alter net wealth but complicates financial management.
Thaler and other behavioral economists cite examples showing biases. An investor might choose to sell a winning stock rather than a losing one due to loss-aversion, even though selling the underperformer often makes more financial sense. This reluctance to acknowledge losses leads to suboptimal investment decisions.
Why Do We Engage in Mental Accounting?
People naturally treat money differently based on its origin and purpose; however, this method often leads to detrimental financial practices after thorough thought.
Is Mental Accounting a Behavioral Bias?
Absolutely. Behavioral biases are irrational beliefs or behaviors unconsciously influencing our decisions, and mental accounting leads to illogical financial management.
How to Prevent Mental Accounting
The key to overcoming mental accounting is to view money as interchangeable, without assigning labels based on its origin. Refrain from treating it differently based on source or future use, especially considering debts with high interest rates.
The Bottom Line
Mental accounting is a common trap, regardless of one’s financial literacy. Assigning subjective value to money can undermine financial stability by promoting illogical decisions. Embracing the fungibility of money is essential for achieving more rational and beneficial financial outcomes.
Related Terms: fungibility, loss aversion, credit card debt, portfolio management.
References
- Richard H. Thaler. “Mental Accounting and Consumer Choice”. Marketing Science, Vol. 4, No. 3 (Summer, 1985). Pages 199-214.
- The University of Chicago Booth School of Business. “Richard H. Thaler”.
- Richard H. Thaler. “Mental Accounting Matters”. Journal of Behavioral Decision Making, 12. Page 183.
- Richard H. Thaler. “Mental Accounting Matters”. Journal of Behavioral Decision Making, 12. Pages 183-206.
- IMDB. “Full Cast & Crew: The Big Short (2015)”.
