Mental Accounting

What is Mental Accounting?

The mental accounting concept was introduced by Richard Thaler in a paper titled “Mental Accounting Matters,” which was published in the Journal of Behavioral Decision Making. Thaler noted that people place the value of money differently, and it exposes them to irrational decision-making. In simple terms, the concept states that individuals classify money differently based on subjective criteria, and it often leads people to make irrational spending and financially counterproductive investment decisions.

The concept suggests that people do not treat money as fungible – i.e., mutually interchangeable – and instead, link their spending to particular budgets. For example, if an individual is paid an end-year bonus of $1,000 for exemplary performance, they may feel that the bonus allows them to spend money on extravagant items, such as meals, lavish vacations, and other expenses that they would never justify spending regular income on. The concept holds that people are more likely to be impulsive with unexpected money because such money was not factored in their financial plan.

How It Works

The concept of mental accounting was introduced in 1999 by Richard Thaler, a professor of Economics at the University of Chicago’s Booth School of Business. The concept was published in a paper titled “Mental Accounting Matters,” and Thaler detailed how mental accounting leads people to make irrational spending and investment decisions. He defined mental accounting as a set of cognitive operations that individuals use to keep track of financial activities.

In debunking the mental accounting theory, Thaler emphasized the concept of fungibility. The concept holds that all money is mutually exchangeable and that individuals should treat all money the same, regardless of the intended use or origin.

Thaler observed that people often violated the fungibility concept when dealing with a windfall situation such as bonuses, tax refunds, lottery winnings, and birthday money. It means that “gift money” that is not part of the individual’s regular income is spent in extravagant expenses that they cannot justify. Therefore, he advised that individuals should treat all money the same and spend windfalls the same way they spend regular income based on a solid financial plan.

Examples of Mental Accounting

The following are common examples of mental accounting:

Tax Refunds

A tax refund is a reimbursement of the excess amount of tax paid by a taxpayer to the federal or state government. If a taxpayer receives a refund, it means they overpaid their taxes in the previous tax year, and this represents an interest-free loan to the government.

Most taxpayers look at tax refunds as a bonus or sort of windfall whose spending has no impact on their financial plan for the year. It is erroneous since tax refunds represent money that rightfully belongs to the taxpayer, and the tax authority only restores an amount equivalent to the overpaid tax. Instead, tax refunds should be treated as a fungible commodity regardless of its origin, and it should be treated the same way as regular income.

Bonuses

A bonus is a payment to a person above and beyond their regular income. Usually, bonuses are awarded as a form of incentive to entry-level and senior-level employees. Companies also use bonuses to reward special achievements or for the accomplishment of certain milestones.

However, employees see bonuses in a different light other than mere ordinary income. As a result, many employees spend their bonuses on unnecessary expenses such as cars, vacations, fancy clothing, etc.

Such spending behavior is against the concept of fungibility. Before spending bonuses on extravagant expenses, employees should compare the expenses with what that the money could alternatively be spent on ­– something that is more deserving of that money.

Lottery Winnings

Lottery winners often spend their fortunes on dubious purchases that are only justified by the unmerited prize they won. As a result, many lottery winners go bankrupt shortly after receiving their prize and spending their fortune on undeserving expenses.

If the fortune had been spent in line with the financial plan that the winners had before the win, they would’ve earned returns on their investments or spent the fortune on justifiable expenses.

Mental Accounting in Investing

Mental accounting also exists in investing, as investors choose the assets to invest in speculative and safe portfolios. Investors disassociate safe portfolios from speculative portfolios so that negative returns from the latter do not affect positive returns from the former. It means that there is extra money that investors can afford to lose and that they are comfortable investing in uncertain and speculative investments.

However, “money that you can afford to lose” is a mental accounting bias, since all money is the same, and there is no decision that would justify losing any money you own. There should be no division between safety capital and money that you can afford to lose, and any dividing line amounts to a mental illusion.

Additional Resources

CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

• Decision Theory
• Moral Hazard
• Prisoner’s Dilemma
• Investing: A Beginner’s Guide
• See all management & strategy resources