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.

  1. Behavioral Economics

    Behavioral Economics is the study of psychology as it relates ...
  2. Silo Mentality

    A silo mentality is an attitude found in some organizations that ...
  3. Rational Behavior

    A decision-making process that is based on making choices that ...
  4. Fungibility

    A good or asset's interchangeability with other individual goods/assets ...
  5. Risk Lover

    A risk lover is an investor who is willing to take on additional ...
  6. Retirement Money Market Account

    A retirement money market account is a money market account that ...
Related Articles
  1. Personal Finance

    What You Can Learn from Economist Richard Thaler

    Economist Richard Thaler won the Nobel Peace Price in 2017 for his groundbreaking behavioral finance work.
  2. Investing

    The Pros and Cons of Using Mental Accounting

    Using mental accounting is beneficial at times, but can be detrimental to your investments.
  3. Investing

    Learn to Avoid This Behavioral Bias When Investing

    A mental accounting bias and the inability of a portfolio to grow over time often results in severe liquidity problems down the line.
  4. Investing

    Don't Let Emotions Derail Investment Decisions

    Understanding behavioral finance can help you make better investing decisions.
  5. Small Business

    7 Ways Your Emotions Skew Your Business Decisions

    Important decisions such as making a key investment, increasing production or expanding into new lines are all clouded by human emotion. Can you stay cool under pressure?
  6. Investing

    Behavioral Finance

    Learn the science behind irrational decision making and how you can avoid it.
  7. Trading

    The Casino Mentality In Trading

    Many new traders treat the market like a casino, placing unwise bets and hoping for the big win.
  1. What is the difference between accounting and economics?

    Discover the difference between accounting and economics by comparing and contrasting the financial discipline of accounting ... Read Answer >>
  2. Why would you keep funds in a money market account and not a savings account?

    Read about the differences between money market accounts and savings accounts, and see why a depositor would elect a money ... Read Answer >>
Hot Definitions
  1. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
  2. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
  3. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
  4. Monte Carlo Simulation

    Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted ...
  5. Price Elasticity of Demand

    Price elasticity of demand is a measure of the change in the quantity demanded or purchased of a product in relation to its ...
  6. Sharpe Ratio

    The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk.
Trading Center