What is Mental Accounting?

Modern economic theory is largely based on consumer decisions being sensible and objective. Studies have shown, however, that mental accounting colors the decision-making process regarding spending and investment choices. Mental accounting is the process of compartmentalizing various investments or expenditures, viewing the different compartments as separate and unrelated to the others. For example, if an individual purchases a latte for $4 US Dollars (USD) and spills it accidentally, he will be highly resistant to purchasing another one, but he will have no problem purchasing $4 USD of gasoline. Although the dollar amounts of the purchases are identical, buying more coffee for $4 USD seems wasteful to the consumer, but purchasing $4 USD worth of gasoline is acceptable to him.

Consumers engage in mental accounting based on purely subjective reasons, like the intent for each account or the source of the money. For example, when consumers receive money for a birthday present, what they do with the money may depend on what the giver stated was the intent for the money. If the giver stated that the money was for a college fund, the consumer is likely to save it. On the other hand, if the giver expressed that the recipient should go out and spend it on something fun, the recipient will do so, even if he owes back money on his rent. Some people save the money that they earn, attributing a greater value to it, but they readily spend money that they receive from others, considering it to be an extra treat.

Mental accounting can significantly affect investments and banking. For example, investors may spend a lot of time and effort maintaining two portfolios, one for “safe” investments and one for riskier investments. In reality, the risk is the same whether the accounts are independent or together. Keeping the two types of investments in a single portfolio allows the investor to more effectively balance the goals of mitigating risk and improving returns. In the same way, consumers may staunchly maintain a college fund in a low-yield savings account, while they mount up an exorbitantly high interest credit card bill.

Economists agree that money is interchangeable, regardless of origin or purpose. Money received as a gift or from a tax refund is not different from earned money. Getting rid of outstanding debt may enhance an economic perspective more than keeping a low-interest savings account. A heightened awareness of the impact of mental accounting through study of behavioral finance can help consumers steer clear of careless spending of “found” money and irrational buying and investment decisions.