Mental Accounting Definition
Mental accounting theory, introduced in the year 1999 by Richard Thaler is a concept in behavioral economics that states that the importance of money and its impact that each individual attaches to the available funds is based upon subjective criteria and can result in irrational spending.
Mental Accounting Bias Example
Following are the examples of mental accounting bias-
- Tax refunds
- Birthday money
- Bonuses
- Safety capital
- The amount of money that is affordable to lose
- Lottery winnings
- Money already spent
- Confusing Identical Purchases.
Example #1
Jim rented a car from Carrentals Limited. The rented car got a little dint when Jim was driving it and the company charged him $800 for that dint. Jim applied to his third party insurer for claiming back $800. Jim thought that upon receiving the claim he will contribute this amount for a charitable cause and if he doesn’t get that back he will not be able to do so at all.
This means Jim is not willing to absorb this loss and dip onto his main savings account. As per mental accounting theory, Jim must treat all the amount of money as fungible. However, in reality, it is very difficult to differentiate savings and unexpected gains/losses.
Example #2
A hungry person can pay $500 for a meal at an expensive restaurant but at the same time, he will not be determined to pay $200 for a better meal at a mediocre restaurant. This is because the former expenditure will fall into the “sophisticated” mental account while the latter would fall into the “normal” mental account.
How Mental Accounting Bias is useful for Marketers?
Mental accounting is useful for retailers in the following ways:
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- The marketers can design appropriate sales and marketing strategies upon learning the weaknesses in customers’ mental accounting and use the same for convincing them to buy things. With the help of this, marketers are able to market their products to customers in various ways. The most common method used by marketers is offering their goods and services at a lucrative discount. Since the customers are not much aware of how mental arithmetic actually works they end up falling into the marketer’s trickery and make unnecessary purchases.
- Mental accounting even assists marketers in building a strong customer base.
- With the help of mental accounting, investors can set-up a savings budget plan for every month and learn how they can allocate their assets. It also allows investors to review their assets on a regular basis.
Mental Accounting Bias in Finance
The treatment of money is not the same for all physical accounts. For example, money in a savings account is treated differently in comparison to the money that is maintained in the brokerage account. Withdrawing money from savings account might be an inconvenient option as compared to the short-term losses suffered from the investments.
Individuals might compromise on their financial progress by more spending their certain inflows like tax refunds, bonuses, etc. Individuals might lose gains if at all they are paying off their low-rate debts faster than what is necessary instead of investing the same money and receiving better returns from it.
Mental Accounting in Investing
Individuals might miss out on considering the risks or correlations of mental accounts when they place every single goal and the wealth that is supposed to be used for the purpose of meeting each goal with respect to a separate mental account.
This might result in generating portfolios that are very similar to a layered pyramid of assets instead of viewing the portfolios as one.
Advantages
Following are the advantages of mental accounting-
- It can help an individual meet investment-related goals. When a certain amount of money is invested in a retirement account then that money cannot be used by the account holder for spending purposes. In this way, he/she can skip unnecessary expenditures and save the same money for the future.
- It helps in the identification and classification of every single goal. This allows retailers, marketers, and individuals to focus on every goal.
- Investors can review and assess the performance of their investments from time to time.
- It helps marketers in building a strong relationship with their buyers.
Disadvantages
Following are the disadvantages of mental accounting-
- It causes individuals to treat money received from different sources in a different fashion. Individuals might feel the urge to spend the inherited money faster in comparison with the money that is earned as a salary.
- It encourages individuals to spend money on useless things and activities.
- It encourages individuals to keep too much amount of money as a cash emergency instead of investing the same or using the same for the repayment of high-interest debts.
- It results in financial inflexibility where individuals are unable to realize and adjust their goals and budgets based on updated financial information.
Conclusion
Mental accounting theory was introduced by a Noble prize winner Richard Thaler in the year 1999. The concept states the fungibility function of money. Bonuses, birthday money, tax refunds, lottery winnings, money already spent, etc are a few examples of mental accounting. The treatment of money may not be the same for all physical accounts.
Money that is kept in a current account will be treated differently as compared to the money that is spent on shares and securities. Individuals might spend their bonuses, birthday money, tax refunds, etc on making more unnecessary purchases instead of using the same for investment purposes. Mental accounting must be wisely used for gaining financial flexibility so that the participants can align their financial goals appropriately.
Recommended Articles
This has been a guide to Mental Accounting and its definition. Here we discuss how mental accounting bias and its theory works for marketers along with the examples. You can learn more about accounting from the following articles-
