Mental Accounting

What is Mental Accounting?

Mental accounting refers to the different values a person places on the same amount of money, based on subjective criteria, often with detrimental results. Mental accounting is a concept in the field of behavioral economics. Developed by economist Richard H. Thaler, it contends that individuals classify funds differently and therefore are prone to irrational decision-making in their spending and investment behavior.

Understanding Mental Accounting

Richard Thaler, currently a professor of economics at the University of Chicago Booth School of Business, introduced mental accounting in his 1999 paper "Mental Accounting Matters," which appeared in the Journal of Behavioral Decision Making. He begins with this definition: "Mental accounting is the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities." The paper is rich with examples of how mental accounting leads to irrational spending and investment behavior.

Underlying the theory is the concept of fungibility of money. To say money is fungible means that, regardless of its origins or intended use, all money is the same. To avoid the mental accounting bias, individuals should treat money as perfectly fungible when they allocate among different accounts, be it a budget account (everyday living expenses), a discretionary spending account, or a wealth account (savings and investments).

They also should value a dollar the same whether it is earned through work or given to them. However, Thaler observed that people frequently violate the fungibility principle, especially in a windfall situation. Take a tax refund. Getting a check from the IRS is generally regarded as "found money," something extra that the recipient often feels free to spend on a discretionary item. But in fact, the money rightfully belonged to the individual in the first place, as the word "refund" implies, and is mainly a restoration of money (in this case, an over-payment of tax), not a gift. Therefore, it should not be treated as a gift, but rather viewed in much the same way that the individual would view their regular income.

Richard Thaler won the 2017 Nobel Memorial Prize in Economic Sciences for his work in identifying individuals' irrational behavior in economic decisions.

Example of Mental Accounting

Individuals don't realize the mental accounting line of thinking seems to make sense, but is in fact highly illogical. For instance, some people keep a special “money jar” or similar fund set aside for a vacation or a new home, while at the same time carrying substantial credit card debt. They are likely to treat the money in this special fund differently from the money that is being used to pay down debt, in spite of the fact that diverting funds from the debt repayment process increases interest payments, thereby reducing their total net worth.

Broken down further, it’s illogical (and, in fact, detrimental) to maintain a savings jar that earns little or no interest while simultaneously holding credit-card debt that accrues double-digit figures annually. In many cases, the interest on this debt will erode any interest you could earn in a savings account. Individuals in this scenario would be best off using the funds they have saved in the special account to pay off the expensive debt before it accumulates any further.

Put in this way, the solution to this problem seems straightforward. Nonetheless, many people do not behave in this way. The reason has to do with the type of personal value that individuals place on particular assets. Many people feel, for example, that money saved for a new house or a child’s college fund is simply “too important” to relinquish, even if doing so would be the most logical and beneficial move. So the practice of maintaining money in a low- or no-interest account while also carrying outstanding debt remains common.

Professor Thaler made a cameo appearance in the movie The Big Short to explain the "hot hand fallacy" as it applied to synthetic collateralized debt obligations (CDOs) during the housing bubble prior to the 2007-2008 financial crisis.

Mental Accounting in Investing

People also tend to experience the mental accounting bias in investing as well. For instance, many investors divide their assets between safe portfolios and speculative ones on the premise that they can prevent the negative returns from speculative investments from impacting the total portfolio. In this case, the difference in net wealth is zero, regardless of whether the investor holds multiple portfolios or one larger portfolio. The only discrepancy in these two situations is the amount of time and effort the investor takes to separate out the portfolios from one another.

Mental accounting often leads investors to make irrational decisions. Borrowing from Daniel Kahneman and Amos Tversky's groundbreaking theory on loss aversion, Thaler offers this example. An investor owns two stocks: one with a paper gain, the other with a paper loss. The investor needs to raise cash and must sell one of the stocks. Mental accounting is biased toward selling the winner even though selling the loser is usually the rational decision, due to tax loss benefits as well as the fact that the losing stock is a weaker investment. The pain of realizing a loss is too much for the investor to bear, so the investor sells the winner to avoid that pain. This is the loss aversion effect that can lead investors astray with their decisions.