Updated: Jan 11, 2021
Ahh, accounting the one class that nearly all finance majors had to take in undergraduate (and the major that's most associated to be for boring people). But luckily, this type of accounting that we will be discussing below won't require any financial accounting. And no, it's not where we do accounting problems in our heads.
So What is Mental Accounting?
Mental accounting is a perfect example of how people behave irrationally. The concept says that people tend to make decisions based on categories that they have mentally created. Although such categories might seem rational in our minds, they are oftentimes misleading.
Why Is This So Dangerous?
Consequently, people make irrational decisions related to their investment and spending habits.
Let’s say that John keeps a jar dedicated to saving for an upcoming vacation to Miami (spring break!) in his apartment. But he also has substantial credit card debt. Due to mental accounting, he is more likely to treat the money in the jar as being more special while also at the same time, neglecting his debt. The most logical action would be to focus on paying off his debt with the money he is saving for the trip he wants to take.
On further thought, it is also irrational to keep the money in a savings jar as it will accumulate no interest while John’s debt will continue to accumulate due to interest rates and extra dues. But John fails to see his erroneous ways because his mentality has deceived him into thinking that he cannot relinquish the money in the jar despite having debt.
How Does Mental Accounting Influence How We Spend Money?
Human beings are more likely to be much more impulsive or risky with money that is not theirs and money that is unexpected. The reason is that the unexpected money was never factored into their financial plans in the first place. In our minds, we thus see this money as being “less important” prompting us to take more risks. Bonuses are a great example, it's the adult version of birthday cash. Many employees spend their bonus money on items that they would never justify buying on their base salary.
This is where many investors fall into. Under this notion, this is money that they feel comfortable with to lose on their risky investments. It is also money that they can “afford” to lose.
This mentality also transfers to the idea of safe portfolios vs risky ones. The premise is that by dividing a large portfolio into two, the returns from the safe portfolios will balance out the negative ones from the risky portfolio. But when calculating the net difference, the result is zero. The investor has thus lost out on time and wasted effort in splitting his portfolios.
An investor who is also impacted by mental accounting could make a decision based on loss aversion. To summarize, loss aversion says that the pain of losing outweighs the gains from winning. Say an investor owns two stocks-one that is performing well and one that is performing poorly. The combined effects of mental accounting and loss aversion will lure his/her decision into selling the well-performing stock to raise cash even though it is logical to sell the poor performing one.
But perhaps the most important takeaway is the fungibility of money. All money is the same and where money comes from should play no part in determining how to spend it. There is no dividing line between “safe money” and “play money”. The honored line that divides them is an illusion that causes individuals to make erroneous choices.