Mental Accounting

Mental accounting is the process of labeling and categorizing money based on varying criteria, such as what the money is for and where the money comes from. Mental accounting impacts how we view money and spend it. Since money is “fungible” or substitutable, we should regard a dollar earned through the stock market and a dollar earned through labor equally. Unfortunately, this is frequently not the case when it comes to finances and spending.

Mental accounting is a common occurrence that happens for a number of reasons. In most instances, people are influenced by their perception of items as they relate to other reference points rather than in absolute terms. For example, categorizing and allocating money based on where it comes from; defining what a “good deal” is; and making decisions based on sales or percentages. Unfortunately, accounting finances like this can create irrational financial decisions. Learn more about how mental accounting can happen in the following common scenarios.

When accounting for our money, we categorize it into different accounts based on different criteria. This results in the notion that money is less fungible or substitutable than it really is. For instance, we tend to separate our regular income from a bonus earned at work and end up using it for discretionary expenses rather than putting it towards other more essential bills.

In reality, every dollar we have holds equal value regardless of its origin or how we spend it. There is nothing different between unexpected funds compared to expected income, but because we feel like it’s special, it gives us justification to spend it however we please.

How we frame our options when making decisions influences our perceptions of them which can lead to bias or irrational decision making. This cognitive bias, called the framing effect, influences our choices based on how the information is presented rather than the information itself.

For example, you may opt for an item that is 5% off $100 than an item that is repriced to $95 from $100. Even though the difference in both scenarios is $5, how it’s framed can affect how you make decisions.

When making a purchase, we often look at its transactional utility or how good of a deal we get from a transaction. Certain situations can dictate the transactional utility of an item or service.

For example, it is well-known that hotels inflate food and drink prices compared to how much they are priced in grocery stores. However, if you were offered a $20 meal in a hotel, you would consider it a deal even though restaurants outside of the hotel offer the same meal for $15 or less. Your circumstances and perspective in this example dictate what is "fair" or a "good deal".

Mental accounting includes associations we place on monetary value by grouping it by varying criteria. This often contradicts the underlying premise that money has a consistent, unchanging value and regardless of where it comes from, it has the same value. However, mental accounting leads us to view money and make purchases according to how we obtain it, plan to use it or how it makes us feel. Explore the following examples to better understand how easily mental accounting can occur.

Mental accounting is present even when we budget. On one hand, it can help us determine how much we’ll spend on something. On the other hand, critically thinking about whether the item is needed or if it’s reasonably priced is not often considered. When we have already allocated funds to purchase something, we fail to analyze the “bigger financial picture.” Mistakes like this drive us to overspend and can harm our attempt at saving money.

Another example of mental accounting and budgeting revolves around your food budget. For many, spending money at a restaurant versus the grocery store can be preferable for various reasons, such as convenience, menu options or experience, even though food shopping at the store provides more value for your money. This scenario highlights how mental accounting can lead you to poor financial decisions.

Mental accounting can also impact your savings. Imagine you’re trying to save and pay off debt and decide to add extra money to your piggy bank. However, if you were to analyze your bigger financial picture, it would be a smarter financial strategy to add the money to a savings account with 20% interest instead of stashing away cash that doesn’t accrue anything over time.

The majority of taxpayers view their annual refunds as an unexpected windfall that has little impact on their financial plan. This is why more often than not, individuals use their tax refunds for discretionary spending.

However, refunds are taxpayers’ over payment throughout the year and must be returned to the taxpayer. The viewpoint that tax refunds are a “bonus” is where mental accounting comes in. The truth is tax refunds should be viewed as fungible assets, independent of their source and treated as regular income.

Monetary bonuses are often issued through the workplace for exceptional accomplishments or when employees reach career milestones. Since they tend to be unexpected income, employees may use it as an excuse to indulge on frivolous items, such as cars, vacations and designer apparel.

This goes against the principle of fungibility where money should be interchangeable; it’s like wasting cash when you spend your bonus on something unnecessary. Instead of spending the bonus on expensive items, employees should consider what the money could be spent on instead.

Credit cards are a convenient and safe way to make purchases, especially when compared with cash. However, credit cards also offer consumers opportunities that can lead them into debt if they are not careful. This is because credit card purchases are easier to compartmentalize in your mind. After all, your actual money isn’t being used when you charge your card and purchases are easy to make when they’re small or spread out over a course of time.

For example, credit card payments are deferred until at least 30 days after the purchase was made. This can lead to irresponsible spending, as small purchases can add up or a big purchase can be made with the thought of paying it off over time.

Separating a credit card’s spending due to mental accounting can be financially risky because the immediate spend is not clear until the bill is due. After all, you still have to factor in credit card interest which can cause your balance to grow quickly if not paid off immediately.

A windfall is when you receive a significant, unexpected amount of money. This can be in the form of an inheritance or finding $100 on the ground. Since this is an unexpected influx, you may treat it separately from your regular income and spend it on luxury items instead of essentials.

When this happens, mental accounting may have you thinking this is a unique occurance and therefore, you might justify splurging with it or using it as play money.

Mental accounting may lead to poor financial decisions. Fortunately, by focusing on changing our spending habits, we can avoid making these mistakes and gain control over how much money is deposited into a bank or savings account or toward credit card monthly payments.

Mental accounting bias can be an investor's worst enemy because it skews perspective and rationale surrounding assets. For example, some people divide their investments between a safe and risky portfolio in order to prevent any negative effects from losing money on more volatile assets. This means that extra money is available for investments that are speculative.

The concept that there is money that you can afford to lose is in itself a mental accounting bias. As all money is the same, there should be no separation between money. No money should be "safe to lose".

Mental accounting can be a confusing concept at first, but once you understand it, you’ll be able to adjust your perspective, work toward strengthening your budget and achieve your financial goals. Below are a few frequently asked questions (FAQs) about mental accounting to help you better understand the concept.

There are many things you can do to avoid mental accounting. From budgeting properly to planning for unexpected income, explore the following guides to help ensure you stay on track with your finances.

• How to Start Saving and Investing: Saving and investing should be part of your financial strategy even from a young age. Learn how to start, no matter what stage in life you're in.
• Saving for Retirement: Planning for retirement requires evaluating your goals and how you’ll get there. Learn how to start saving now and take advantage of compound interest to retire sooner.
• Hold Yourself Accountable and Stick to Your Financial Goals: Mental accounting can easily keep you from achieving your financial goals sooner. Learn how to take control of your finances and save more.
• Reduce Monthly Spending: If you’re looking for ways to cut back on expenses to save more, review these 25 ways to reduce your monthly expenditures.
• Main Types of Debt and How to Pay Them Off: Cutting back on debt is something everyone should prioritize to give themselves more resources for later. Learn the different types of debt and how to eliminate them in this guide.