Mental accounting
Mental accounting derives its name from the perception that people tend to have ‘mental accounts’ for different economic decisions. People tend to put money into different ‘mental accounts’ based on arbitrary classifications. As a consequence, they trend to treat money spent in the different accounts differently.
Examples
The effect is best illustrated using some examples. First, we consider a short example provided by Richard Thaler, who first documented the mental accounting. A thirsty beer drinker will probably be willing to pay $4 for a beer at an expensive resort. This consumption will be put in the ‘holiday’ mental account. At the same time, he might refuge paying $2.5 for the same beer in a grocery store because this expenditure in the ‘grocery shopping’ mental account.
As a second example, let’s assume you are waiting in line at the box office of a cinema. When you are about to pay and take out your wallet, you realize that you’ve lost a $10 bill. Now image that you had purchased the ticket in advance and realized that you forgot the ticket (which cost $10) at home. Even though the amount of money is the same, people tend to perceive both situations differently. In particular, most people would not purchase a new ticket when they forgot it at home, but they would buy the ticket had they lost the $10 bill. The reason is that people already spent $10 to the ‘going to the cinema’ mental account. As such, they are therefore unwilling to spend even more on the category. At the same time, the $10 bill lost, is in the ‘money lost’ account.
Mental accounting in finance
Even though the above examples were money-related, there are also clear examples that related directly to investing. Money in different physical accounts is also often treated differently. For example, you will probably view money on your savings account differently from money at your brokerage account. You might find redrawing money from your savings accounts to be more unpleasant than short-term losses on you investments.
Advantages and disadvantages
There are both advantages and disadvantages to mental accounting. For example, mental accounting may help you meet certain investment goals. By putting the money in a retirement account, you might view that money as being ‘not available for spending prior to retirement’. A disadvantage of mental accounting is that it also causes you to treat money that you receive from different sources differently. You might classify money that you inherited in the ‘windfall revenue’ account and spend it more quickly than you would spend your ‘paycheck’ money.
Summary
Sometimes it is useful to treat different pools of money differently. However, money is just money. Whatever the mental account it is assigned to, it will impact your wealth in exactly the same way.