mental accounting

What is Mental Accounting?

Mental accounting is when a person assigns different values ​​to 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 argues that individuals categorize funds differently and are therefore prone to irrational decisions in their spending and investment behavior.

key takeaways

  • Mental accounting is a behavioral economics concept coined by Nobel Prize-winning economist Richard Taylor in 1999, which refers to the different values ​​people assign to money based on subjective criteria, which often have harmful outcomes.
  • Mental accounting often leads people to make irrational investment decisions and act in counterproductive or harmful ways, such as funding low-interest savings accounts while holding large credit card balances.
  • To avoid psychological accounting bias, individuals should treat funds as fully fungible when allocating different accounts, be it a budget account (daily living expenses), a discretionary spending account, or a wealth account (savings and investments).

Understanding Psychological Accounting

Richard Thaler, now a professor of economics at the University of Chicago Booth School of Business, introduced mental accounting in his 1999 paper, “The Problem of Mental Accounting,” published in the Journal of Behavioral Decision Making. He starts with this definition: “Mental accounting is a set of cognitive operations that individuals and households use to organize, evaluate, and track financial activities.” The paper has many examples of how mental accounting can lead to irrational spending and investment behavior.

The theory is based on the concept of money fungibility. Saying that money is fungible means that all money is the same regardless of its origin or use. To avoid psychological accounting bias, individuals should treat funds as fully fungible when allocating different accounts, be it a budget account (daily living expenses), a discretionary spending account, or a wealth account (savings and investments).

Whether earned through work or given to them, they should also value a dollar equally. However, Taylor observes that people often violate the principle of substitutability, especially in the case of windfalls. Apply for a tax refund. Getting a check from the IRS is often considered “find money,” which is an extra item that the recipient can usually spend at will. But in fact, as the term “refund” implies, the money is meant to belong to the individual in the first place, and is primarily a recovery of money (in this case, overpaid taxes), not a gift. Therefore, it should not be viewed as a gift, but in the way an individual views their regular income.

Richard Thaler was awarded the 2017 Nobel Prize in Economics for his work on identifying irrational behavior of individuals in economic decision-making.

Examples of Mental Accounting

The idea of ​​mental accounting that individuals do not realize seems plausible, but is actually very illogical. For example, some people keep a special “piggy bank” or similar fund for a vacation or a new home while carrying a lot of credit card debt. Although transferring money from the debt service process increases interest payments, reducing their total net worth, they may treat the money in this special fund differently than the money used to service the debt.

Breaking it down further, maintaining a piggy bank that earns little or no interest while holding on to credit card debt that generates double-digit numbers each year is illogical (and actually harmful). In many cases, the interest on this debt can eat into any interest you could earn in your savings account. In this case, individuals are better off using the funds they keep in special accounts to pay off expensive debts before they accumulate further.

With that said, the solution to this problem seems simple. Still, many people don’t behave that way. The reason has to do with the type of personal value an individual places on a particular asset. For example, many believe that saving money for a new home or a child’s college fund is simply “too important” to pass up, even if doing so is the most logical and beneficial move. As a result, the practice of placing funds in low- or no-interest accounts while taking on outstanding debt is still common.

Professor Taylor has a cameo in the movie big short Explain the “hot hand fallacy” as it applies to synthetic collateralized debt obligations (CDOs) during the housing bubble preceding the 2007-2008 financial crisis.

Investing in Psychological Accounting

People also tend to experience mental accounting bias in investing. For example, many investors divide their assets into safe and speculative portfolios, on the premise that they can prevent negative returns from speculative investments from affecting the entire portfolio. In this case, the difference in net wealth is zero whether the investor holds multiple portfolios or a larger portfolio. The only difference between the two cases is the time and effort investors spend separating their portfolios from each other.

Mental accounting often leads investors to make irrational decisions. Thaler provides this example, drawing on the seminal theory of loss aversion by Daniel Kahneman and Amos Tversky. An investor owns two stocks: one with a paper gain and the other with a paper loss. Investors need to raise cash and have to sell one of the shares. Mental accounting is biased towards selling winners, although selling losers is usually a rational decision due to taxes on lost earnings and the fact that losing stocks is a weaker investment. Realizing that the pain of loss is unbearable for investors, investors sell winners to avoid the pain. This is the loss aversion effect, which can lead investors astray.

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