What Is the Concept of Mental Accounting & Why It Is Important?

The different values we as people put on the same amount of money based on subjective or emotional criteria is our mental accounting. This type of accounting may seem useful or at the very least harmless but it is simply bad for us.

Mental Accounting has been studied and popularised by behavioral economist Richard Thaler. He says that we tend to ‘mentally classify’ money even though money is just money (i.e. it's fungible), leading to both irrational spending and irrational investments.

For most of us, money received unexpectedly is always considered more spendable or put in the ‘can afford to risk’ category. In reality, money categorized as ‘can afford to risk’ and money categorized otherwise/for safekeeping/monthly budget, etc. should be treated with the same diligence.

For example: I had planned to wait until the end of the year to buy new clothes because I already have too many, but since I received some money as a Diwali bonus, I feel free to do it now.  Now, the logic for not spending on clothes remains intact but since I treat bonus money differently and not as regular money, I end up making an irrational spending decision.

Mental accounting also causes us to look at identical spending as being different. Consider this scenario which was tested on respondents in a study conducted by Princeton University -

Imagine you just arrived at a cinema and as you reach into your pocket to pull out the Rs 200 ticket you purchased in advance, you discover that it’s missing. 

Would you spend over another Rs. 200 to see the movie?

Compare that to a second scenario in which you did not buy the ticket in advance, but when you arrive at the cinema, you discover you lost a Rs. 200 note. Would you still buy a movie ticket?”

Having just read nearly an entire article on mental accounting, you no doubt realize that each scenario has the same outcome: a loss of Rs. 200 i.e. it does not matter (financially speaking) whether you watch the movie or not!

The bottom line is, whether we like to believe it or not, money is money. It’s not salary money cashback money or Rakhi money. It is all the same thing and should be thought of as such. A simple way to correct mental accounting is to think of your money minus any categorizations.