Mental accounting

Self Assessment

Mental accounting is a cognitive bias that refers to the tendency for people to categorize and treat money differently based on arbitrary categories, like the source of the money or its intended use. It often involves simplifying the probabilities and impacts of financial decisions, impacting economic behavior and individual decision-making.

How it works

Mental accounting works by segregating funds into different 'mental accounts' that are earmarked for specific purposes or originate from different sources. For example, a person might have a mental account for necessary expenses, one for leisure activities, and another for savings. Money is not freely transferable between these mental accounts, which can lead to irrational financial behavior.

Examples

  • A person receives a large tax refund and decides to splurge on a vacation, but would hesitate to do the same if they received the equivalent amount through regular salary increments over the year.
  • Investors might treat money invested in stocks differently from money saved in cash, even though both are part of the same overall personal wealth.

Consequences

The consequences of mental accounting can include suboptimal financial decisions, such as overspending on discretionary purchases while not saving enough for retirement. This can lead to financial strain or the inability to achieve long-term financial goals.

Counteracting

To counteract mental accounting, individuals should strive to integrate all their financial resources into a comprehensive budget, and make financial decisions based on overall financial status rather than having separate accounts for each category. Additionally, awareness and education about this bias can help individuals make more rational decisions.

Critiques

Critics of the concept of mental accounting argue that it oversimplifies human behavior and disregards the complex motivations behind financial decisions. Others suggest that while mental accounting can lead to seemingly irrational behavior, it can also serve as a practical tool to help people manage their finances by psychologically imposing self-discipline.

Fields of Impact

Psychology & Social Science
Behavioral Science
Economics & Finance

Also known as

Mental Budgeting
Cognitive Budgeting

Relevant Research

  • Mental Accounting Matters

    Richard Thaler (1999)

    Journal of Behavioral Decision Making

  • The Psychology of Sunk Cost

    Hal R. Arkes and Catherine Blumer (1985)

    Organizational Behavior and Human Decision Processes

  • Prospect Theory: An Analysis of Decision under Risk

    Daniel Kahneman and Amos Tversky (1979)

    Econometrica

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