Mental Accounting Definition Mental Accounting Bias

Mental Accounting Definition

Mental accounting theory, introduced in 1999 by Richard Thaler, is a concept in behavioral economics that states that the importance of money and the impact each individual attaches to the available funds is based upon subjective criteria and can result in irrational spending.

Mental Accounting Bias Example

Following are the examples of mental accounting bias:

Tax refundsBirthday moneyBonusesSafety capitalThe amount of money that is affordable to loseLottery winningsMoney already spentConfusing identical purchases

Example #1

Jim rented a car from Carrentals Ltd. Unfortunately, the rented car got a little dint when Jim was driving it, and the company charged him $800 for that dint. So, Jim applied to his third-party insurer to claim back $800. Jim thought that upon receiving the claim, he would contribute this amount to a charitable cause, and if he didn’t get that back, he would not be able to do so.

Jim is unwilling to absorb this loss and dip it into his main savings account. As per mental accounting theory, Jim must treat all the money as fungible. However, it is very difficult to differentiate savings and unexpected gains/losses in reality.

Example #2

A hungry person can pay $500 for a meal at an expensive restaurant, but at the same time, he will not be determined to pay $200 for a better dinner at a mediocre restaurant. The former expenditure will fall into the “sophisticated” mental account, while the latter would fall into the “normal” mental account.

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How is Mental Accounting Bias useful for Marketers?

Mental accounting is useful for marketers in the following ways:

The marketers can design appropriate sales and marketing strategies upon learning the weaknesses in customers’ mental accounting and use them to convince them to buy things. With the help of this, marketers can market their products to customers in various ways. Marketers’ most common method is offering their goods and services at a lucrative discount. Since the customers are unaware of how mental arithmetic works, they fall into the marketer’s trickery and make unnecessary purchases.Mental accounting even assists marketers in building a strong customer base.With the help of mental accounting, investors can set up a savings budget plan for every month and learn how they can allocate their assets Allocate Their AssetsAsset Allocation is the process of investing your money in various asset classes such as debt, equity, mutual funds, and real estate, depending on your return expectations and risk tolerance. This makes it easier to achieve your long-term financial goals.read more. It also allows investors to review their assets regularly.

Mental Accounting Bias in Finance

The treatment of money is not the same for all physical accounts. For example, money in a savings account is treated differently from the funds maintained in the brokerage accountThe Brokerage AccountA brokerage account is a taxable investment account in a brokerage company where a person deposits its assets and instructs the company to trade in shares or bonds on their behalf. In addition, the company deducts some brokerage or commission.read more. Withdrawing money from a savings account might be an inconvenient option compared to the short-term losses suffered from the investmentsInvestmentsInvestments are typically assets bought at present with the expectation of higher returns in the future. Its consumption is foregone now for benefits that investors can reap from it later.read more.

Individuals might compromise on their financial progress by spending more on certain inflows like tax refunds, bonuses, etc. Individuals might lose gains if they pay off their low-rate debtsDebtsDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more faster than what is necessary instead of investing the same money and receiving better returns.

Mental Accounting in Investing

Individuals might miss out on considering the risks or correlations of mental accounts when they place every goal and the wealth supposed to be used to meet each goal concerning a separate mental account.

It might generate portfolios similar to a layered pyramid of assets instead of viewing the portfolios as one.

Advantages

Following are the advantages of mental accounting:

It can help an individual meet investment-related goals. When a certain amount of money is invested in a retirement account, that money cannot be used by the account holder for spending purposes. In this way, they can skip unnecessary expenditures and save the same money for the future.It helps in the identification and classification of every single goal. It allows retailers, marketers, and individuals to focus on every plan.Investors can review and assess the performance of their investments from time to time.It helps marketers in building a strong relationship with their buyers.

Disadvantages

Following are the disadvantages of mental accounting:

It causes individuals to treat money received from different sources differently. Individuals might feel the urge to spend the inherited money faster than the money earned as a salary.It encourages individuals to spend money on useless things and activities.It enables individuals to keep too much money as a cash emergency instead of investing the same or using the same to repay high-interest debts.It results in financial inflexibility where individuals cannot realize and adjust their goals and budgets based on updated financial information.

Conclusion

Nobel prize winner Richard Thaler introduced mental accounting theory in 1999. The concept states the fungibility function of money. Bonuses, birthday money, tax refunds, lottery winnings, money already spent, etc., are a few examples of mental accounting. The treatment of funds may not be the same for all physical accounts.

Money kept in a current account will be treated differently from the money spent on shares and securities. Individuals might use their bonuses, birthday money, tax refunds, etc., to make more unnecessary purchases instead for investment purposes. They must wisely use mental accounting to gain financial flexibility so that the participants can align their financial goals appropriately.