What Is Mental Accounting Bias?

According to standard economic theory, USD 100 should be worth the same no matter how it was earned. Behavioral finance, however, disagrees. According to behavioral finance, people tend to assign different values to equal sums of money depending on how they were obtained. This concept was developed by behavioral economist Richard Thaler and is called “mental accounting”. In this article, we will explore mental accounting bias and its effect on investment behaviour.

What is mental accounting?

The term “mental accounting” was first introduced by Richard Thaler in a paper published in the Journal of Behavioral Decision Making titled “Mental Accounting Matters”. According to Thaler, the way people perceive the value of money leads them to make illogical decisions. 

Essentially, mental accounting holds that individuals define money differently based on subjective factors, which often leads to irrational spending and investment decisions. In other words, people often make subjective financial decisions (based on emotional judgments or reasoning), and this can easily harm them without their realizing it.

The concept also shows that individuals assign sums of money to specific uses rather than treating them as interchangeable. For example, if someone performs outstandingly at work and receives a year-end bonus of VND 20 million, they may allow themselves to spend it on luxury goods, fancy restaurants or long holidays, whereas they would never do so if that VND 20 million were their monthly income. 

Examples of mental accounting

Tax refunds, bonuses and lottery winnings are classic examples of how mental accounting influences human behaviour:

Tax refunds

This is money that taxpayers have paid to the tax authorities over and above their actual obligation, and which is refunded to them. In practice, most taxpayers treat a tax refund as a bonus, or as money that does not really affect their annual budget. That view is wrong, because the money actually belongs to the taxpayer; it is their own money, not a bonus. 

Bonuses

A bonus is money employees receive on top of their regular salary. Bonuses serve as encouragement and motivation for employees, especially a company’s senior staff. Companies also use these incentives to recognize outstanding achievements or important milestones.

Employees, meanwhile, often view bonuses differently from their regular pay. As a result, many employees spend their bonuses on things they do not really need at the time, such as cars, travel or expensive clothes. Spending like this goes against the principle of fungibility. Before spending a bonus on excessive purchases, employees should consider whether the money could be put to better use elsewhere.

Lottery winnings 

People who win the lottery and become rich sometimes squander their fortune on things they do not really need, things they could only afford because of the windfall they suddenly received. As a result, many lottery winners go bankrupt not long after becoming rich.

How does mental accounting affect investing?

By nature, personal investing is heavily influenced by investors’ subjective judgments and opinions. Investing is therefore closely tied to mental accounting. 

The author argues that all money (spent for any purpose) is interchangeable, and people should treat it equally, no matter how it was earned or what it is to be used for.

According to Thaler, people often ignore the principle of fungibility when it comes to bonuses, tax refunds or lottery winnings. Research shows that “gift money”, “money that fell from the sky” or “money it doesn’t matter if I lose” is the money most likely to be spent irrationally. The author therefore recommends that individuals treat all money equally and spend it the same way as ordinary income, with a sound financial strategy. How does mental accounting affect investing?

If someone decides to reinvest the profits they have earned, their appetite for risk increases markedly. For example, if someone invests VND 10 million earned through hard work, they will invest it extremely carefully. But if that VND 10 million comes from earlier gains, the investor will certainly not hesitate to take bigger risks with capital gains they regard as free money.

What are the pros and cons of mental accounting? 

What are the pros and cons of mental accounting?

Although it describes hidden disadvantages that people are often unaware of, mental accounting also has some advantages:

Mental accounting can help individuals reach their investment goals. For example, when building up a retirement account, it is important not to withdraw money midway but to stay persistent and disciplined in saving. Here, mental accounting helps us draw a clear line: this is an investment for the future, not an ordinary spending account. That way, we become more disciplined, avoid wasteful spending and set aside money for the future.

Through mental accounting, investors can clearly separate what they are investing in, so they can review and evaluate their investment performance regularly and make sensible adjustments.

Despite these advantages, mental accounting also has some drawbacks:

Mental accounting makes people distinguish between money from different sources, encouraging them to spend on inappropriate things, as in the examples above. It also makes people want to keep a pile of idle cash, like an emergency fund, instead of investing it or using it to pay off the high-interest debts they are carrying.

Overall, mental accounting is a well-known concept in behavioral finance. Because it has both pros and cons, we need to recognize its presence in each of our financial decisions so we can think things through carefully and make the most effective decisions.

Happy Trading!

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