Mental Accounting and Financial Decision Making

 

Mental accounting is a behavioral economics concept that people separate their money into discrete buckets based on subjective criteria. These buckets are often based on the source of the money or the intended use of the money (1).

Recent work has found the effects of mental accounting are influenced by individual personality traits and cognitive factors (2), such as the perception of scarcity (3).

Mental accounting provides a theory as to why people treat sources of income differently. For example, people treat tax refunds differently than their paycheck. The differential treatment occurs despite the fact that a tax refund and a paycheck are both simply sources of income (4).

Through mental accounting people often place a tax refund in the “found money” bucket. They then use the tax refund for frivolous expenditures rather than saving for their future. This may occur because a tax refund is an unexpected and infrequent event (i.e. “found money”).

Compare this with the expected and frequent income from a weekly paycheck. People may be more likely to save for the future rather than splurge with their weekly paycheck. This may occur because the paycheck is mentally placed in the “earned money” bucket. Mentally, “earned money” is for necessary expenditures, such as groceries, bills, and retirement.

Mental accounting can also lead to irrational investment decisions (4,5). For example, people may hold separate accounts for “risky” investments and “safe” investments. The “risky” investments may be held despite large losses simply because they were mentally placed in the “risky” bucket. After all, mentally, this money is for speculation.

The “safe” investments could be held long after growth prospects have been exhausted simply because they were mentally placed in the “safe” bucket. After all, mentally, this money is for investments that are sure to provide steady and stable returns.

In reality, money is interchangeable across accounts and the mental accounting bias could be limiting financial returns. Continuing to hold declining investments or those with lack of growth simply because o how the accounts were mentally labeled is a recipe for poor performance.

Mental accounting has its benefits (4). If you have a hard time resisting spending, or are saving for something special, placing funds in a “special expenditure” bucket could keep you focused on your goal and resist spending money earmarked for other activities. Likewise, an investor who likes to speculate could hold a separate account for “risky” investments to refrain from losing money earmarked for less speculative investment.

Conclusion: Be aware of the negative, and positive, impact of mental accounting. Awareness of mental accounting can improve financial decision making.

References:

1. Thaler R. Mental accounting and consumer choice. Marketing Science, 1985; 4:199-214.

2. Muehlbacher S. & Kirchler E. Individual differences in mental accounting. Frontiers in Psychology, 2019; 10. doi: 10.3389/fpsyg.2019.02866.

3. Cheng L., Yu Y., Wang Y. & Zheng L. Influences of mental accounting on consumption decisions: asymmetric effect of a scarcity mindset. Frontiers in Psychology, 2023; 14. doi: 10.3389/fpsyg.2023.1162916.

4. Thaler R. Mental accounting matters. Journal of Behavioral Decision Making, 1999; 12:183–206.

5. Barberis N. & Huang M. Mental accounting, loss aversion, and individual stock returns. Journal of Finance, 2001; 56:1247-1292.

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