What is Mental Accounting

Mental accounting is an economic concept established by economist Richard H. Thaler, which contends that individuals classify personal funds differently and therefore are prone to irrational decision-making in their spending and investment behavior. Mental accounting is subject matter in the field of behavioral economics.

BREAKING DOWN Mental Accounting

Richard Thaler introduced mental accounting in his 1999 paper "Mental Accounting Matters," which appeared in the Journal of Behavioral Decision Making. He begins with his definition: "mental accounting is the set of cognitive operations used by individuals and households to organize, evaluate and keep track of financial activities." The paper is rich with examples of how mental accounting leads to irrational spending and investment behavior. Underlying the theory is the concept of fungibility (substitutability) of money. Individuals should treat money as perfectly fungible when they allocate among a budget account (everyday living expenses), discretionary spending account, and a wealth account (savings and investments).

They also should value a dollar the same whether it is earned through work or given to them (a windfall situation). However, Thaler observed that people frequently violate the fungibility principle. A simple example that many people can relate to is a tax refund. A tax refund is generally regarded as a type of windfall, "found money" that the recipient feels free to spend on a discretionary item, when in fact it rightfully belonged to the individual in the first place and could go into the savings account.

Mental Accounting at Work in Investing

Investors who perform mental accounting can make irrational decisions. Borrowing from Daniel Kahneman and Amos Tversky's groundbreaking theory on loss aversion, Thaler offers this example: an investor owns two stocks — one with a paper gain, the other with a paper loss. The investor needs to raise cash and must sell one of the stocks. Mental accounting is biased toward selling the winner even though selling the loser is the rational decision in most cases due to tax loss benefits as well as the fact that the losing stock is a weaker investment. The pain of realizing a loss is too much for the investor to bear, so he sells the winner to avoid that pain. This is the loss aversion effect that can lead investors astray with their decisions.

Who is Richard Thaler?

Richard Thaler (1945 - ) is a professor of economics at the University of Chicago Booth School of Business. Professor Thaler won the 2017 Nobel Prize in Economics for his work in identifying and explaining possible reasons for irrational behavior in economic decisions by individuals. As a fun fact, Professor Thaler made a cameo appearance in the movie "The Big Short" alongside pop singer Selena Gomez to explain the "hot hand fallacy" as it applied to synthetic CDOs (collateralized debt obligations) during the housing bubble prior to the financial crisis of 2007-2008.