What is Mental Accounting?

Mental accounting can lead people to make irrational investment decisions.

Many people separate their money into different ‘accounts. For example, they might keep the money they make and the money they spend in other places. But this is not a good idea. It is like owning your income and your expenses apart.

Mental accounting is a product of the field of behavioral economics. It suggests that individuals classify funds differently and are prone to irrational decision-making in their spending and investment behavior.

If people spend their money differently, they might make bad choices. They need to consider all of their options for spending.

Here’s an example: a gift certificate is a gift to you. You can use it to buy something in the store. It could be used for a down payment on something that is on sale in the store. The gift certificate can also be saved for next year’s birthday present.

People think of money as cash in their hands

People make this mistake because they think of money as cash in their hands instead of thinking about having it in an account.

Typically, when we look at our checking account balance, we’re looking at fungible money. When we label some of our money for rent or groceries, it is harder to use that money for other things because we cannot use it for anything.

Why is Mental accounting important in finance and investment?

This concept can be especially problematic when it comes to investments. For example, many people have separate accounts for short-term needs (like an account at a local bank) versus long-term goals (like an IRA or mutual fund). 

This might make you feel like you’re spending your money twice. You should put your extra cash in your retirement account if you can. That’s just one of several ways mental accounting can lead investors astray—another is treating stocks as more valuable than they are.

The bottom line? By applying different rules to at least some portion of your money, you might end up making irrational financial choices—and not even realize it. 

To avoid mental accounting bias, individuals should treat money as perfectly fungible when allocating among different accounts. Money is not the same as it used to be. 

The money we have might not be in our bank account. It could be on a card or a computer, and that doesn’t matter. What matters is how much money you have for what you need and want.

The Role of Emotional Accounting

What is the cause of the mental accounting bias? Behavioral finance theorists have attributed it to an individual’s focus on losses, gains, and emotional responses. 

In studies, individuals have been discovered to prefer a certain gain of $X or a risk-free opportunity to make $X-$Y for sure. Many people choose the latter option because it reduces loss aversion, even though both options return the same expected value mathematically.

According to the behavioral economist Richard H. Thaler, people perceive money differently. They are thus more likely to make poor financial decisions when it comes to their spending and investing behavior.

To further test this hypothesis, Thaler designed an experiment that manipulated subjects’ feelings by associating different outcomes with distinct moods—either happy or sad music played during payouts. 

Applying different rules to your money might make you irrational

If you get money as a loss (e.g., if you pay for something that does not happen), you feel sad. If you earn money as a gain (e.g., if someone gives it to you), it makes you happy.

Thaler concluded that people make financial decisions partly emotionally, and manipulating their mood can affect their spending behavior—a conclusion since verified in many experiments.

Thaler found that people experiencing losses tend to be riskier investors than those who have experienced gains. Losses make them want to recover their money quickly, making them less likely to hold stocks with long-term value. 

But this element of risk aversion only has for individuals affected by mental accounting biases. People who do not engage in these cognitive processes are less sensitive about “sunk costs.”

This illogical behavior is an example of mental accounting

People can think differently about the things they own. This is called cognitive biases. From a mental accounting perspective, people typically consider money in terms of how they may best use it to achieve their present and future financial goals. 

People also tend to treat money differently based on where or when they acquired it or what intention they obtained it. If you have the same amount of money, but only one is from your job, and the other is from a tax refund, people will think they are equal. 

But the one from your job is more. For this reason, mental accounting may lead to outcomes that are at odds with other, more logical processes of money management.

Mental Accounting Bias

When you have different items with the same value, it can be hard to know which one is best. This is called decision-making. The mental accounting bias is an example of a cognitive bias. 

Other examples include the gambler’s fallacy, loss aversion, and confirmation bias. These all illustrate the various ways in which human beings often make decisions that defy logic.

People spend less when using a credit card than cash because they feel psychologically richer if they pay with a credit card. This is because the money has not yet been spent. Again this fails to take into account opportunity costs.

Mental Accounting real example

Thaler offers another example of loss aversion. An investor has $2 million in bonds that he needs to sell. The bonds pay him $100,000 annually for the next five years and then will mature, at which point the investor will receive $2 million. 

A second investment earns an annual return of 6%. Does Thaler ask whether it is better to sell the first investment or the second? If past returns drive investors, they will keep both assets because the first one had more significant gains than the second one. 

However, suppose investors act rationally rather than past value. In this situation, they should keep the investment that only earns 6% because it will make $300,000 over five years. 

This is more than the $100,000 which they could get from selling the first investment. In both examples (selling the losing stock or the bond), it is rational to take the loss to avoid future pain. 

Mental accounting People perceive money differently

Still, investors tend to act irrationally because they are affected by loss aversion. The emotions of fear and regret drive their decisions instead of rationality.

When there is a loss, it feels worse than when there is a profit. Risk-averse people will be afraid to sell their stocks when they are winning instead of continuing them. They will also hold on to their losing stocks even if they can get better returns by selling them. 

When you make financial decisions, it is a good idea to think about things. Sometimes people can make a wrong decision because they do not think about what has happened in the past.

Mental Accounting Bias – Loss Aversion

People experience a much stronger negative emotion when they lose something than they feel pleasure when they see an equal value gain. 

The difference, called the marginal utility of gains and losses, is not based on any measurable or observable characteristic but instead reflects how people feel about their money. 

People are always looking to avoid loss, even if it means making irrational decisions. For example, investors may hold onto losing stocks because selling would admit that their original selection was unwise. 

This realization might trigger feelings of regret, which typically include ruminating over all the other alternative decisions that people could have made instead. 

This can lead to poor financial decisions because there is no good objective reason for holding onto the losing stock other than the fear of taking the loss.

Mental Accounting Bias – Behavioral Therapy

Behavioral therapy can help to overcome the mental accounting bias. This is when you make decisions that are not based on reason but rather ignorance. Individuals might behave differently in an irrational way if they knew about the mental accounting bias. 

This could lead to them making bad decisions. Knowing this form of cognitive irrationality allows investors to make more informed choices (which they should act upon) instead of decisions influenced by emotions like regret or guilt.

This fallacy has two main effects: The first effect is that people assume sunk costs are relevant.

Conclusions

In economics and finance, mental accounting refers to informal accounting systems for evaluating gains and losses. It involves separating one’s wealth into “mental accounts” or “sub-portfolios,” with each mental account governed by its version of the axioms of choice under uncertainty. 

In some cases, mental accounting is different from other asset management methods, such as portfolio theory. 

People who use mental accounting sometimes do not behave in a consistent way with expected utility theory or some versions of portfolio theory. Still, others say that this inconsistency can be explained. It depends on the situation.