Mental Accounting

Traditional economic theory assumes that all money is fungible. The meaning of the word fungible is "interchangeable." Hence, according to economic theory, if we have $100, the value of that should be the same for us regardless of how that was obtained. However, behavioral finance theory argues that this is not the case. According to behavioral finance, people attribute different values to the same sum of money, depending upon how it was earned. This concept is called mental accounting and was developed by a psychologist named Richard Thaler. In this article, we will have a closer look at what mental accounting is as well as how it impacts investing behavior.

What is Mental Accounting?

As we have already mentioned above, mental accounting is the tendency to assign different mental values to the same sum of money. In order to actually understand this concept, we need to relate to it. Hence, some examples where mental accounting has been explained are mentioned below:

People generally treat their earned income and income received from a gift very differently. For instance, a person is likely to spend a $500 paycheck much more cautiously. This is because this money is perceived as a fruit of effort. There is some emotional value attached to it, as well. However, if the same amount is received as a gift, people tend to be much more reckless with their spending. This happens because mentally earned income and gifts are put into two different accounts.

People tend to be very careful when they spend large sums of money. However, they do not seem to pay attention when small sums of money are involved. For example, if any person has to make a single expense of $3500, they will be very careful about it. They will find out their options and try to optimize their decision. However, when it comes to spending $10 per day, people do not seem to put much thought into their actions. This is strange given the fact that $10 per day would amount to almost the same on an annual basis.

People tend to become cautious when they receive lump sums of money. Hence, if a person were to receive a $100,000 inheritance, they would make their decisions very carefully. However, if they were to receive the same money in a hundred installments of $1000 each, the odds are that they would not be equally cautious.

People tend to spend the same amount of money differently if they spend using cash or using credit cards. There is a psychological pain associated with giving up cash. Hence, it has been observed that people will spend the same amount of money differently depending upon whether they have to pay using cash or using credit cards.

Lastly, there are some sums of money that people tend to earmark as sacred. For some people, it might be the equity in their house. For other people, it might be their retirement accounts. However, people often refrain from touching the money in these accounts even if they have to borrow the same money at higher rates of interest for other purposes.

Each of these above cases is relatable. Either we ourselves have behaved like this with money in the past, or we know people who have done the same.

How Does Mental Accounting Impact Investment?

Investors who have a written budget tend to earmark a certain percentage of their incomes towards investments. The fact that there is a written budget with a number on it increases the pressure to actually make these investments. This is because there is a mental investment account that needs to be closed by paying money. However, if an investor does not earmark the money and decides to pay the residual amount towards investments, they tend to invest less.

The risk tolerance of a person increases rapidly if they are reinvesting their earnings. For instance, if a person invests their own hard-earned $10000, then they are likely to be very cautious. However, if that $10000 has been turned into $20000 because of capital gains, then the investor is likely to take excessive risks with the capital gains. This is because capital gains are mentally characterized as free money, and hence people don't mind taking excessive risks with them.

Day traders tend to enter and exit stocks at very narrow spreads. Often, after the transaction costs and taxes are accounting for, they are barely covering the cost of their capital. However, since the money is earmarked for risky day trading investments, they do not mind paying the exorbitantly high costs associated with such trading.

When people receive lump sums of money, they become overly cautious. People with lump sum money are likely to put all of it in safe, low-yield investment options. However, people who receive the same amount in monthly installments are likely to prefer high-yielding equity investments. The right thing to do would be to apportion the money between the two investments. However, it is difficult to do the same because of biases resulting from mental accounting.

One of the hallmarks of a successful investor is that they do not fall into this mental accounting bias. Instead, they decide to evaluate each investment on its numerical merits. This is the reason that they are able to make better financial decisions.