How Mental Accounting Affects Our Money Decisions

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Happy New Year! If the memes on social media were any indication, most people were glad to see the end of 2020. According to People Magazine, a survey conducted by OnePoll found that 47 percent of Americans said 2020 was a difficult year for them financially, and nearly three quarters of those surveyed are resolving to be smarter about money in 2021.

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Saving Money In The New Year

Money goals often surface as part of New Year’s resolutions. Research by YouGov found that nearly half of those surveyed about their 2020 resolutions included one related to saving money. Often, resolutions involve creating a budget to track expenses, paying down debt, or saving for retirement. How we manage these types of activities often involves something called “mental accounting.”

Most of us are familiar with the concept of business accounting. Investopedia describes it as “the process of recording financial transactions pertaining to a business,” and defines the accounting process as including “summarizing, analyzing and reporting” transactions. We approach household budgeting in largely the same way, often creating expense categories to help us track spending and saving throughout the year. However, we often don’t treat all our money in the same way, and sometimes, that can lead to poor money decisions. Here are a couple of examples:

Jana put in a lot of hours on a project at work and was surprised when her boss decided to give her a spot bonus of $350. Instead of putting the money into savings, Jana decided to splurge on some new clothes. “This was an unexpected windfall,” Jana told herself. “It won’t hurt to treat myself since the expenditure won’t impact my budget.”

The Tax Refund

Mark, a self-employed graphic designer, pays his estimated taxes quarterly and didn’t anticipate the tax refund he received in 2020. Although he had used his credit card to buy the software he needed for his business and still had an outstanding balance, he decided to spend his tax refund on a much-needed vacation instead of paying down his credit card debt. “I’ll pay off my credit card over the next six months with the money I’ve budgeted,” he thought. “Using my tax refund means I can go on vacation without adding to my debt.”

Behavioral finance expert Richard Thaler first popularized the concept of mental accounting in his article, “Mental Accounting Matters,” which appeared in the Journal of Behavioral Decision Making in 1999. Thaler found that while in theory, we should treat every dollar the same way, regardless of where it came from, in practice, we treat it very differently. He cited three different components: 1) how we perceive and experience outcomes, and how those affect our decision-making; 2) how we assign activities to specific accounts; and 3) the frequency with which we evaluate our accounts (also called choice bracketing by Read, Loewenstein and Rabin (1998)). As Thaler wrote, “…mental accounting violates the economic notion of fungibility. Money in one mental account is not a perfect substitute for money in another account. Because of violations of fungibility, mental accounting matters.”

The Consequences of Mental Accounting

“Fungibility, of course,” said Thaler, “is the notion that money has no labels.” As Thaler put it, the effect of winning a $300 football pool should be the same as having a stock in which 100 shares increase by $3 per share or having the value of your pension increase by $300. The “marginal propensity to consume” (MPC) all types of wealth is supposed to be equal, according to Thaler, assuming no transaction costs, etc. But we all know that’s not the case. For example, think about the way you might value lottery winnings versus the money in your retirement account. You wouldn’t think about blowing your retirement, but you might consider using your lottery winnings to purchase a new car, a new home, or some other extravagant item.

The truth is, when we separate our money into buckets, we tend to think about each bucket differently. If we’re out of money in one bucket, we might consider delaying a purchase, while
spending on less useful items in other budget categories. We might be risk averse when it comes to our rainy-day fund, but more aggressive when it comes to investing. Or we might be reluctant to use emergency funds in a low-interest account to pay down debt with high interest. Our mental accounting can keep us from making sound financial decisions when faced with new information.

But despite the previous examples, mental accounting does have its benefits. Even money expert Dave Ramsey advocates an “envelope” system for categorizing and tracking budgets and preventing overspending. If you’ve used such as system, you may have benefited by anticipating the need for an emergency fund and tapping it instead of your retirement to make ends meet during a difficult time.

Defining Your Money Goals

Categorizing your expenses may also help you when it comes to defining your money goals. Because you need to decide how much to allocate in each of your budget buckets, mental accounting can lead you to prioritize what’s most important to you now and for the long term.

Even though mental accounting is a “bias” that causes us to make subjective decisions, Thaler saw no reason to worry about it. He wrote, “Mental accounting procedures have evolved to economize on time and thinking costs and also to deal with self-control problems. As is to be expected, the procedures do not work perfectly.” Thaler recommended that those who wish to improve their individual decision making can use mental accounting as a prescriptive device but warned that repairing one problem could create another. “If we stop being lured by good deals, do we stop paying attention to price altogether?”

In my opinion, recognizing our biases can help make us more effective at managing money; however, I don’t believe we’ll ever eliminate biases completely. There will always be sellers and buyers, opportunities and threats, optimism and pessimism. Understanding how we react to these stimuli can lead to more thoughtful decision-making and improved money habits.