Remember your first pay packet and the thrill of deciding what to spend or save. Did you choose to use it all up in one go or split it into different amounts? If you held a portion back, what did you decide to do with it? Did you have short term goals, long term?
Mental accounting can be described as compartmentalising or dividing up a sum of money, including where it came from, into arbitrary accounts or categories and applying different decisions based on those categories. It explains how we assign a subjective value to our money, often in ways that go against economic principles in our best interest.
Budgeting or Mental Accounting
The phenomenon “Mental Accounting” is a form of bias as it affects how we think and behave. First described formally by Richard Thaler, a Nobel Prize winner for work in behavioural economics in 1985. His work sets out to research and explains how people behave in real life. Mental accounting is one example of a bias that opposes how traditional economists expect humans to behave in certain circumstances.
Most of us use mental accounting in one form or another when creating budgets for ourselves, our households, or the workplace. Setting aside accounts, or pots, for different purposes can take the form of a complex spreadsheet, individual accounts at the same or different banks or even money boxes or envelopes labelled up at home.
Creating a budget affects how we spend our money by applying rules to how we earn it, spend it on, and how using it makes us feel. This concept of how we sort information and how it determines how we think about it is called contextualisation.
Jason Voss describes the following example of creating a business budget into different categories for spending money. Then a situation arises that you have overspent in one area and underspent in another and report to management.
When this happens, typically, you might get criticised for spending more than the allotted amount. However, nobody is likely to congratulate you for saving money in the other category to the same extent.
As a business, the total amount of money is mutually interchangeable; it’s all the same pot of money, after all. Yet, by portioning it into a budget, different rules and judgements are driven by this arbitrary categorisation.
Examples of mental accounting
- Say you receive an unexpected windfall and use some or all of it for a special occasion. Ordinarily, you would be saving towards that big purchase in the future, but this time, as you weren’t expecting it, you treat yourself.
- You’ve assigned a portion of your pay towards eating out, and once you’ve spent that for the month, you’ll cook meals at home. When you hit that threshold for eating out early in the month, you stop doing so for the remainder until you get paid again.
- You keep a separate tab of the actual value of your emergency fund in the form of a minimum balance, only to be used to cover emergencies without actually moving it from a general account.
- After making some winnings from gambling at the casino, you pay yourself back what you brought in while committing to only stake the ‘house money’ for the remainder of the night.
Mental accounting is assumed to serve at least three essential purposes which are to:
- Simplify decision making
- To maintain self-control when facing tempting opportunities
- To maximise pleasure from making a decision
Muehlbacher and Kircher phrase it differently, saying that we use mental accounting to “keep track of expenses for things we like and to save money for things we don’t like but still have to pay”.
Make mental accounting work for you
Overcoming the bias can be challenging, given that humans prefer to take shortcuts in their thinking wherever possible. However, simply knowing where your thinking is taking shortcuts can lead you to make better decisions.
Avoid purchasing goods or services on credit
Research has shown that people are willing to pay more for goods using credit cards instead of paying cash. The separation between obtaining a good or service and paying for it is also known as payment or transaction decoupling.
With cash and debit transactions, there is an implicit requirement to confirm sufficient funds are available before purchasing anything using your mental accounting. This process of having to work out where the money is coming from immediately and experience that as an immediate loss of money results in more intentional decision making over whether to make the purchase.
Most people who are loss averse can use this to benefit financially. For example, by avoiding expenditures on a credit card, even one paid off automatically each month using a debit card can reduce overall spending and increase savings.
Spending
When we use mental accounting, we value money differently depending on where it comes from — money won on the lottery or as a bonus is more likely to be spent quickly. When we receive money expectedly, we often see it as a windfall. Conversely, we might split the same money earned from work between different accounts for saving and spending.
What we expect to pay compared to the actual amount also affects how we choose to spend our money. We give much less thought to an extra £500 on an expensive purchase like a house or a car than spending an additional £500 on a new television. Or the choice between your favourite coffee a few times a month over a pricer mobile phone contact. Both lose you the same amount of money, though mental accounting makes us choose different choices in different contexts.
If we want to avoid this type of mental accounting bias when spending, it is essential to recognise that all spending is the same; saving £10 per month of a mobile phone contract to spend it on a coffee three times per month is self-defeating. It is better to be intentional with our spending and understand the inherent opportunity cost with each purchase we make.
Investing
Many investors separate pots into various categories based on risk, holding a more extensive ‘safe’ portfolio and a smaller speculative portfolio. As a result of mental accounting, there is a tendency to make risker investments that can have more considerable losses in the risker portfolio, assuming that this is “money that I can afford to lose”. We also make distinctions between the money we want to build for retirement and that which is to fund short term goals.
However, since all money is the same, there should be no distinction between capital held in safe or risky portfolios. After all, it has a purpose for you as an investor, and any division is simply a mental trick.
A popular way of avoiding shortcuts in investing is to keep an investing journal that details why you are making a specific investment and, importantly, your goals for the investment. In the same way as using cash or debit transactions, this intentional coupling of the reason behind your investment and carrying out the trade asks you to consider whether it is suitable for your circumstances.