Mental Accounting

Updated on April 17, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Mental Accounting?

Mental accounting theory, introduced in 1999 by Richard Thaler, is a concept in behavioral economics that states that the importance of money and the impact each individual attaches to the available funds is based upon subjective criteria and can result in irrational spending.

Mental Accounting

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Money kept in a current account will be treated differently from the money spent on shares and securities. Individuals might use their bonuses, birthday money, tax refunds, etc., to make more unnecessary purchases instead of investment purposes. They must wisely use mental accounting to gain financial flexibility so that the participants can align their financial goals appropriately.

Key Takeaways

  • Mental accounting is a concept in behavioral economics that shows the importance of money and the impact each individual connects to the available funds based on subjective criteria, resulting in irrational spending.
  • Richard Thaler introduced mental accounting in 1999. 
  • Mental accounting bias examples are tax refunds, birthday money, bonuses, safety capital, the money amount affordable to lose, already spent money, and confusing similar purchases.
  • It helps marketers make a solid customer base, helps design suitable sales and strategies on learning the weaknesses of the customers, and uses them to convince them to buy the products. 

How Does Mental Accounting Work?

Mental accounting is the description of the spending psychology of consumers where they categorize and evaluate the economic outcomes. The mental accounting theory covers the various thought processes that go through consumers’ minds while making choices relating to spending. Below are a few points that are the most common facets of consumer psychology.

  • Tax refunds
  • Birthday money
  • Bonuses
  • Safety capital
  • The amount of money that is affordable to lose
  • Lottery winnings
  • Money already spent
  • Confusing identical purchases

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Mental Accounting for Marketers

Mental accounting theory is useful for marketers in the following ways:

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 from the funds maintained in the brokerage accountThe Brokerage AccountA brokerage account is a taxable investment account in a brokerage company where a person deposits its assets and instructs the company to trade in shares or bonds on their behalf. In addition, the company deducts some brokerage or commission.read more. Withdrawing money from a savings account might be an inconvenient option compared to the short-term losses suffered from the investmentsInvestmentsInvestments are typically assets bought at present with the expectation of higher returns in the future. Its consumption is foregone now for benefits that investors can reap from it later.read more.

Individuals might compromise on their financial progress by spending more on certain inflows like tax refunds, bonuses, etc. Individuals might lose gains if they pay off their low-rate debtsDebtsDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more faster than what is necessary instead of investing the same money and receiving better returns.

Mental Accounting in Investing

Individuals might miss out on considering the risks or correlations of mental accounts when they place every goal and the wealth supposed to be used to meet each goal concerning a separate mental account.

It might generate portfolios similar to a layered pyramid of assets instead of viewing the portfolios as one.

Examples

Mental accounting bias is a common finding in people’s spending behavior. As in, spending the same amount of money at different places. Let us understand this bias and this concept in detail with the help of a couple of examples.

Example #1

Jim rented a car from Carrentals Ltd. Unfortunately, the rented car got a little dint when Jim was driving it, and the company charged him $800 for that dint. So, Jim applied to his third-party insurer to claim back $800. Jim thought that upon receiving the claim, he would contribute this amount to a charitable cause, and if he didn’t get that back, he would not be able to do so.

Jim is unwilling to absorb this loss and dip it into his main savings account. As per mental accounting theory, Jim must treat all the money as fungible. However, it is very difficult to differentiate savings and unexpected gains/losses in reality.

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 dinner at a mediocre restaurant. The former expenditure will fall into the “sophisticated” mental account, while the latter would fall into the “normal” mental account.

Advantages & Disadvantages

The mental accounting bias that consumers deal with on a daily basis has its share of advantages and disadvantages. Let us learn about them in depth with the help of the discussion below.

Advantages

  • It can help an individual meet investment-related goals. When a certain amount of money is invested in a retirement account, that money cannot be used by the account holder for spending purposes. In this way, they can skip unnecessary expenditures and save the same money for the future.
  • It helps in the identification and classification of every single goal. It allows retailers, marketers, and individuals to focus on every plan.
  • 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

  •  It causes individuals to treat money received from different sources differently. Individuals might feel the urge to spend the inherited money faster than the money earned as a salary.
  • It encourages individuals to spend money on useless things and activities.
  • It enables individuals to keep too much money as a cash emergency instead of investing the same or using the same to repay high-interest debts.
  • It results in financial inflexibility where individuals cannot realize and adjust their goals and budgets based on updated financial information.

Frequently Asked Questions (FAQs)

What is mental accounting effect?

Mental accounting helps to view money as less exchangeable and makes one naive to biases like the sunk cost fallacy. In short, it affects one’s thinking capability concerning spending.

How to overcome mental accounting?

One may overcome mental accounting by following the three ways: Firstly, one must systemize their finances. Secondly, note it down instead of keeping it in mind. Thirdly, keep an accounting person to help you from the accounting traps.

What are the mental accounting components?

The mental accounting components are value function, transaction utility, and fungibility. The value function displays the gains and losses concerning a particular reference. The transaction utility applies that through a transaction, people may benefit from the value of the good and the transaction’s value. Finally, fungibility refers to the concept that money has no labels, and individuals do not relate money with anything.

What is cognitive bias mental accounting?

The cognitive bias mental accounting makes ordinary investors avert interaction between assets in various mental accounts. Hence, one must prefer portfolios, not on the mean-variance effective boundary.

This article is a guide to what is Mental Accounting. We explain its examples, relevance to marketing, finance, and investing along with its advantages. You can learn more about accounting from the following articles: –

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