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Mental Accounting: Definition & Example

Instructor: Yuanxin (Amy) Yang Alcocer

Amy has a master's degree in secondary education and has taught math at a public charter high school.

Do you view your money in separate chunks? The concept of mental accounting says that you do. Learn how this can affect your spending and investing choices in this lesson.

Definition

Mental accounting is an interesting thing and is the topic of this lesson. By definition, mental accounting refers to the way people categorize money. According to mental accounting, people place value based on which category the money falls into. Some categories are worth more than other categories. This can sometimes go against logic.

For example, Sally has allocated a $10 bill in the trip jar to taking her next trip. Even if she is short on her rent by $10, she won't use it. This is because the value, the worth, of the money in that trip jar is more valuable than money she uses for her rent. She'd rather borrow the $10 she is short from someone rather than use her trip jar money.

This concept of mental accounting was established by Richard Thaler who has published articles on the topic in 1985, 1990, and 1999. He has since written a book on the topic in 2015, Misbehaving: The Making of Behavioral Economics.

Spending Behavior

Take a look at this spending scenario and ask yourself what you would do. You might be surprised.

You are taking a break from work and are at the local hamburger joint. You are about to purchase your favorite bacon cheeseburger with fries combo meal for $8. As you get ready to pay for your meal, however, you notice that you are short by $8 in your wallet. Thinking back, you realize that you might have lost that money when you were jogging this morning. You think about it, and you decide to purchase your meal. The $8 was lost, and there's nothing you can do about it.

Now, what if, after purchasing your cheeseburger and fries combo meal, you trip and your food ends up all over the floor. Would you go ahead and purchase another cheeseburger and fries combo meal?

Traditional economics says that you would react in the same manner in both scenarios since you have lost the same amount of money, $8. But surprisingly, research shows that more people, 88 percent actually, end up buying when the money is lost, and only 46 percent buy when they have to replace a lost item that has already been purchased.

The above shows how mental accounting affects the way you spend your money. You may not actively think about it, but subconsciously you are partitioning your money and placing more or less value on your money depending on which category you have put your money in.

You can actually think of it in accounting terms as well. When you have to replace an item that has already been purchased, you need to make two transactions from the same account. But, when you lose money, that lost money goes in a different lost-money account, and you are only making one transaction for your item.

Investing Behavior

This behavior that can sometimes be illogical also affects the investing choices people make. According to mental accounting, people will separate their money into a savings portion and another portion they can be risky with. For the savings portion, people will choose investments that are less risky. But for the other, risky portion, people are okay with choosing investments that have more risk associated with them. By doing this, people think that they are protecting their assets, the portion set aside for savings.

But, this mental accounting behavior, when it comes to investing, also goes against logic. In the end, whatever money the person has is what he is worth. It doesn't matter that he is separating his money like that in his head. Whatever money he has is what he has.

Example

Here's another example of how mental accounting can go against logic. Also, for this example, think about what you would do.

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