Mental Accounting

You must have heard of the TikTok trend ‘Girl Math’, where women illogically justify their spending habits. For example, if I buy a $250 purse and use it daily, it will cost me less than a dollar each day which means it is free. This is an example of a concept in behavioural economics called ‘Mental Accounting’. Mental accounting is when an individual places a different amount of importance on the same amount of money based on subjective criteria or subjective rules. 

This concept was introduced by Nobel-Prize-winning economist Richard H. Thaler, currently a professor at UChicago. He defined mental accounting as “the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities."

Mental accounting occurs because individuals tend to label money depending on where they got it from and how they intend to use it. Money is fungible. Fungibility means that all units of money are interchangeable and individuals should treat the money the same, irrespective of where it originated from. However, in mental accounting, we consider money to not be fungible. This leads to individuals spending money differently, depending on where the money originated from. For example, Jack is trying to save money to buy a Mercedes-Maybach S-Class. When he is walking on a road, he randomly finds a $100 bill lying on the road. Instead of saving that $100 bill to buy his dream car, he spends that money for eating at a 5-star restaurant, justifying it as additional money he has earned that isn't meant for buying a car. 

Another reason for mental accounting is the concept of transactional utility. Transactional utility is the happiness a person gets from the perceived value of a deal. For example, you go to watch a movie in a theatre. The price of M&Ms is more than what you pay at a convenience store. However, you still buy the M&Ms because of the enjoyable experience of eating M&Ms while watching the movie. We don’t care about the objective value of money in this case. 

Mental accounting can lead to individuals making bad investment decisions. Investors tend to create two separate portfolios for safe investments and speculative investments to protect their safe investments from the losses that could be incurred from speculative investments. They consider speculative investments the “extra” money they can afford to lose. However, by treating speculative investments as “extra money”, they take on more risk and could incur unnecessary losses. Money is fungible, so this mental illusion cannot justify losing money. 

The bottom line is one should avoid falling into the trap of money accounting when making financial decisions. For this, one should consider all money the same and not put mental labels on it. By doing this, you can create a proper budget, taking into account your spending and unexpected income gains to avoid spending money on unnecessary items.