Mental Accounting and Its Effect on Financial BehaviourJanuary 11, 2024
Mental accounting is an extremely useful concept that can change how we spend, budget and save. Its importance cannot be overstated!
Saving money is a key aspect of financial wellbeing and success. Unfortunately, however, many individuals fall prey to mental accounting bias; learn how to overcome it so your savings and financial habits improve!
Behavioral economist Richard Thaler defines mental accounting as “the tendency to think of value in relative rather than absolute terms.”
Mental accounting explains why spending money through credit cards feels different than when paying cash, as well as why we value items more highly just because they belong to us – something known as endowment effects.
Mental accounting also encompasses how we perceive “found money”, such as tax refunds or work bonuses, differently from regular income. While it would make more sense for us to put these windfalls toward debt repayment rather than spend them, many do so instead.
As such, this can lead to some seemingly irrational decisions. For example, losing a movie ticket that you already paid for can feel like an enormous emotional blow whereas losing cash that had been saved up could be less of a worry.
People who engage in mental accounting are susceptible to the sunk-cost fallacy.
Mental categorizing of accounts and wallets where you hold money may seem like a sensible solution, but this can lead to poor financial decisions. For instance, if you find $100 on the street and you’ve been saving for a car purchase, but then find $100 again somewhere unexpected, this might lead to spending it instead on something unnecessary for that purpose (say an expensive dinner instead of car purchase).
The Sunk-Cost Fallacy (SCF) is one of a host of psychological biases that can impair decision making. According to research by Bruine de Bruin, Strough and Parker, individuals’ susceptibility to SCF depends on how they perceive their current state of mind – older adults tend to be less prone than younger people due to focusing more on positive information and hence being less prone to succumbing to SCF.
Richard Thaler’s behavioral economist views suggest that we should evaluate gains and losses individually so as to minimize pain while increasing pleasure – an approach he refers to as “mental accounting”. Unfortunately, most of us fail at doing this – this phenomenon being termed by him “mental accounting”.
They are more likely to believe marketing tactics.
Mental accounting is a behavioral bias that causes individuals to categorize money differently and make irrational spending decisions. Simply put, mental accounting refers to our tendency of viewing value relative rather than absolute. Scarcity mindsets and the sunk cost fallacy may all influence mental accounting negatively.
Assuming you have separate funds set aside for vacations and debt payments, chances are good you will treat the money in each differently due to mental segregation – meaning their values have altered as a result of this psychological divide.
As is frequently the case, the key takeaway from mental accounting research is that in order to avoid falling into its traps it’s essential that one be purposeful with his/her financial habits – including planning ahead and creating budgets – if they want to avoid unwise financial decisions that lead to overspending. Without being mindful enough with spending habits one may end up spending beyond their means; hence why understanding its effects on decision-making processes is so vitally important.
They are more likely to spend money they don’t have.
Mental accounting is a behavioral bias that can lead to excessive spending and financial counterproductive behaviors, including assigning different values for money based on subjective criteria and making irrational investment decisions such as funding low-interest savings accounts with tax refunds.
Mental accounting also increases people’s risk of spending money they don’t have as it influences how people view money based on its source or purpose.
For example, if you find $100 on the street, it may be tempting to place it in your piggy bank rather than spending it lavishly – especially because your mindset classifies this money as “found money” rather than “car money”. Yet all money should be treated equally regardless of its source; therefore it is crucial that a plan be in place in case unexpected income and gains arises.