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. House Money Effect

    The tendency for investors to take more and greater risks when ...
  2. Behavioral Funds

    Behavioral funds are a category of mutual funds that use behavioral ...
  3. Behavioral Economics

    Behavioral Economics is the study of psychology as it relates ...
  4. Frame Dependence

    Frame dependence is the human tendency to view a scenario differently ...
  5. Silo Mentality

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

    Rational behavior is a decision-making process which results ...
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. Trading

    Understanding Investor Behavior

    Discover how some human tendencies can play out in the market, posing the question: are we really rational?
  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. 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?
  5. Trading

    The Casino Mentality In Trading

    Many new traders treat the market like a casino, placing unwise bets and hoping for the big win.
  6. Investing

    Modern Portfolio Theory Vs. Behavioral Finance

    Or: How financial markets would work in an ideal world vs. how they work in the real world.
  7. Trading

    On This Day In Finance: July 6 - The United States Adopts The Dollar

    The U.S. adopts the dollar as a monetary unit.
  1. What is cost accounting?

    Learn about the main benefits of cost accounting systems, how they are different from financial accounting and why they are ... Read Answer >>
  2. How safe are money market accounts?

    Learn the difference between a money market account and a money market fund. Both savings vehicles are relatively safe, but ... Read Answer >>
Hot Definitions
  1. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  2. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  3. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  4. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  5. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  6. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
Trading Center