What is Mental Accounting?

Updated: August 21, 2023

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What is Mental Accounting?

Mental accounting is a cognitive bias, first introduced by Nobel laureate Richard Thaler.

It refers to our tendency to categorize and treat money differently based on its source, intended use, or emotional significance.

At its core, mental accounting is how our minds compartmentalize money into different mental accounts.

For instance, you might have separate mental accounts for your job salary, freelance work income, and cash gifts. These accounts can lead to positive and negative outcomes depending on how they influence your spending and saving habits.

The Three Aspects of Mental Accounting

Mental accounting has three aspects:

1. Segregation of Funds

Mental accounting often leads us to separate money into specific buckets, such as daily expenses fund, emergency fund, travel fund, and so on.

This can help us manage our finances more efficiently but, unfortunately, it also limits our flexibility.

For example, your emergency fund is in a low-risk, low-interest savings account. If you stumble upon a good investment opportunity, you will most likely hesitate to invest the money in your emergency fund.

This has both advantages and disadvantages. It’s good that you’re not touching your emergency fund, but you could be missing out on earning extra cash from this investment opportunity.

2. Emotional Spending

Mental accounting is closely tied to our emotions.

Money from unexpected windfalls or cash gifts may be treated less cautiously and spent more freely than your regular work income.

This is why some people would splurge or go shopping instead of paying off debts when they receive cash rewards or bonus commissions.

3. Loss Aversion

Mental accounting can cause someone to experience loss aversion.

When we perceive losses in one mental account, we tend to be more risk-averse and conservative in decision-making.

For instance, if your retirement fund that is invested in a mutual fund experiences a loss in value due to market fluctuations, you might become more reluctant to invest more money into it, even if it’s a sound decision from a long-term perspective.

How to Manage Mental Accounting

1. Consolidate and Simplify

While mental accounting can have benefits, too much compartmentalization can hinder your financial progress. Consider consolidating multiple accounts into broader categories that align with your goals.

If you have several types of investments, it’s better to put everything under one mental account – your investment portfolio.

This way, you can rebalance your allocations more effectively and optimize the returns of the whole portfolio instead of the individual investments.

2. Set Clear Goals

Be intentional about the mental accounts you create and the goals they represent.

By setting clear priorities for each account, you’ll be less likely to make impulsive decisions that deviate from your financial objectives.

3. Be Flexible

While it’s important to allocate funds responsibly, don’t shy away from adjusting your mental accounts when circumstances change.

Adaptability is vital to achieving long-term financial well-being.

4. Avoid the “Sunk Cost” Fallacy

Mental accounting can lead to the “sunk cost” fallacy, where individuals hesitate to abandon a failed investment or project because they’ve already invested significant money.

Assess decisions based on their current and future potential rather than fixating on past performance.

5. Consider Opportunity Costs

When evaluating spending decisions within specific mental accounts, also consider the opportunity cost—the potential benefits you forego by choosing one option over another.

This broader perspective can help you make more informed choices.

In Conclusion

Mental accounting is a powerful psychological tool that positively and negatively shapes our financial behaviors.

By understanding how it affects your financial decisions, you can make more informed choices and invest in alignment with your long-term financial goals.

Remember, you don’t need to be afraid or even avoid doing mental accounting.

Use its principles to your advantage while staying aware if its disadvantages are already limiting you. This thoughtful balance will help you better manage your finances and achieve sustainable financial well-being.

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