What Is Mental Accounting?

꧂Mental accounting refers to the different values a person places on the same amount of money based on subjective criteria.

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 are therefore prone to irrational decision-making in their spending and investment behavior.

Understanding Mental Accounting

In his 1999 paper "Mental Accounting Matters," Richard Thaler, currently a professor of economics at the University of Chicago 澳洲幸运5官方开奖结果体彩网: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."

Underlying the theory is the concept of the 澳洲幸运5官方开奖结果体彩网: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 it among different accounts. They also should value a dollar the same whether it is earned through work or given to them.

Thaler observed that people frequently violate the fungibility principle, especially in a windfall situation. Take a 澳洲幸运5官方开奖结果体彩网: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 overpayment 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.

Example of Mental Accounting

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 澳洲幸运5官方开奖结果体彩网: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 thi🧸s 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.

The solution to this problem seems straightforward yet 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 rem🐠ains common.

Mental Accounting in Investing

People also tend to experience mental accounting bias when investing. For instance, many investors divide their assets between safe portfolios and specu൲lative ones on the premise that they can prevent the negative returns from speculative investments impacting the to🧔tal portfolio.

In this case, the difference in net wealth is zero, regardless of whether th♌e 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 the portfolios from one another.

Borrowing from 澳洲幸运5官方开奖结果体彩网:Daniel Kahneman and Amos Tversky's groundbreaking theory on 澳洲幸运5官方开奖结果体彩网: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.

The Bottom Line

Mental accounting is a trap that many incl♊uding seasoned investors fall into. The majority of people assign subjective value to money, usually based on where it came from and how it’s intended to be used. While that approach may sound harmless and totally reasonable, it can work against us and leave us economically worse off.