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  1. Behavioral Finance: Introduction
  2. Behavioral Finance: Background
  3. Behavioral Finance: Anomalies
  4. Behavioral Finance: Key Concepts - Anchoring
  5. Behavioral Finance: Key Concepts - Mental Accounting
  6. Behavioral Finance: Key Concepts - Confirmation and Hindsight Bias
  7. Behavioral Finance: Key Concepts - Gambler's Fallacy
  8. Behavioral Finance: Key Concepts - Herd Behavior
  9. Behavioral Finance: Key Concepts - Overconfidence
  10. Behavioral Finance: Key Concepts - Overreaction and Availability Bias
  11. Behavioral Finance: Key Concepts - Prospect Theory
  12. Behavioral Finance: Conclusion

By Nathan Reiff

Mental accounting refers to the tendency people have to separate their money into different accounts based on miscellaneous subjective criteria, including the source of the money and the intended use for each account. The theory of mental accounting suggests that individuals are likely to assign different functions to each asset group in this case, the result of which can be an irrational and detrimental set of behaviors.

Many people use mental accounting. What these individuals may not realize, though, is that this line of thinking is in fact highly illogical. For instance, some people keep a special “money jar” or similar fund set aside for a vacation or a new home while at the same time carrying substantial credit card debt. (For more insight, see Digging Out Of Personal Debt.)

In the example of the “money jar,” individuals are likely to treat the money in this special fund differently from money that is being used to pay down debt, in spite of the fact that diverting funds from the debt repayment process increases interest payments, thereby reducing the person’s total net worth. Broken down further, it’s illogical (and, in fact, detrimental) to maintain a savings jar that earns little or no interest while simultaneously holding cred-card debt accruing double-digit figures annually. Individuals in this scenario would be best off using the funds they have saved in the special account to pay off the expensive debt before it accumulates any further.

Put in this way, the solution to this problem seems straightforward. Nonetheless, many people do not behave in this way. The reason for this has to do with the type of personal value that individuals place on particular assets. Many people feel, for example, that money saved for a new house or a child’s college fund is simply “too important” to relinquish, even if doing so would be the most logical and beneficial move.

The Different Accounts Dilemma

Consider this example, which is designed to illustrate the importance of different accounts as related to mental accounting: you have set for yourself a lunch budget for each week and you are purchasing a $6 sandwich for lunch. As you go to buy the sandwich, one of the following events takes place: 1) you find that you have a hole in your pocket and have lost $6; or 2) you buy the sandwich, but as you go to take a bite, you trip and the sandwich falls on the floor. In either case (assuming you still have enough money), does it make sense to buy another sandwich? (To read more, see The Beauty Of Budgeting.)

Taken logically, the answer to both scenarios should in fact be the same, as it relates to your total weekly lunch budget. In actuality, though, many people would behave differently depending upon the scenario and as a result of the mental accounting bias. For that reason, many people in the first scenario would go ahead and buy another sandwich based on the feeling that the lost money was not part of the lunch budget, as it had not yet been spent or allocated to that particular account.

Different Source, Different Purpose

A related aspect of mental accounting suggests that people tend to treat money differently depending upon the source of that money. “Found” money, including tax refunds and work bonuses as well as gifts, tends to be spent more freely than money earned through normal paychecks. Again, logic would suggest that these monies should be treated in the same way, but real world scenarios show otherwise.

Mental Accounting in Investing

People also tend to experience the mental accounting bias in investing as well. For instance, many investors divide their investments between safe portfolios and speculative ones on the premise that they can prevent the negative returns from speculative investments from impacting the total portfolio. In this case, the difference in net wealth is zero, regardless of whether the investor holds multiple portfolios or one larger portfolio. The only discrepancy in these two situations is the amount of time and effort the investor takes to separate out the portfolios from one another.

Avoiding Mental Accounting

For investors looking to avoid the mental accounting bias, it’s crucial to remember that money is fungible; regardless of its origins or intended use, all money is the same. Keeping this in mind allows investors to cut down on frivolous spending of “found” money, to avoid wasting time separating out accounts, and so on.

For many investors, the practice of maintaining money in a low- or no-interest account while also carrying outstanding debt remains a common practice. In many cases, the interest on this debt will erode any interest you could earn in a savings account. It’s important to have savings, but in many cases it is more rational to forgo some of that savings in order to pay off debt.

Behavioral Finance: Key Concepts - Confirmation and Hindsight Bias
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