Definition: The inclination to categorise and treat money differently depending on where it comes from, where it is kept, or how it is spent.
Reference:Richard Thaler: outlined one of the most common and costly money mistakes: mental accounting - the tendency to value some dollars less than others and therefore waste them.
Example: When gift or rebate income is valued differently to earned income.
Insight: Mental accounting goes against the concept that money is "fungible" - money should hold the same significance regardless of where it comes from.
Insight: Mental accounting can have benefits - particularly for saving or financial goals.
Insight: Mental accounting becomes a problem because of human self-control.
Insight: Signs of someone prone to mental accounting: (1) doesn't think they are a reckless spender but has trouble saving; (2) has saving in the bank but revolving balances on credit cards (3) more likely to spend a tax refund than savings (4) spend more when paying on card than cash.
Principle: Regularly audit your personal accounting systems.
Principle: Pause before spending "found" money.
Principle: Treat all income as earned - before spending imagine how long it would take to earn.
Principle: Use mental accounting to your advantage for savings - automate savings and put into hidden accounts.
Reference: Richard Thaler introduced mental accounting and that we think about money in the same way organisations do to budget.
Insight: Mental accounting is irrational, but it can be useful if used well - it can help us plan finances and control spending.
Insight: When mental accounting rules are vague, they are malleable, and this can weaken our self-control - we create loopholes and often make poor financial decisions.
Insight: We have cognitive limitations with financial information and opportunity costs - mental accounting can be a useful heuristic to simplify decision making.
Insight: Mental accounting is not rational, but it is sensible.
Insight: Mental accounting occurs because we do not assign the same value to each one of our dollars (fungibility), we place them in categories - which leads to biased decision making.
Insight: If there is money left over in one of our mental accounts it is easy to spend it.
Insight: Mental accounting is a flaw in how we think about money - in a rational world we should treat money as fungible.
Definition: A system that households, or individuals evaluate, regulate, and process their home budget.
Example: At the casino, gamblers tend to treat winnings differently - usually they are more willing to take risks.
Insight: One of the core properties of money is that it is fungible, meaning that no matter where it comes from a unit of currency holds the same value as a unit of the same currency (a dollar is a dollar is a dollar). Mental accounting violates this principle - accounts are treated differently.
Insight: We can take advantage of mental accounting with our savings, by directing funds automatically into 'accounts' where we will not see it or be tempted to spend.
Insight: We usually adopt mental accounting to control spending. It can work against us when we underestimate (we can be left without sufficient funds) or overestimate (we tend to spend the excess anyway) a particular budget item.
Insight: Mental accounting is a form of narrow framing that is manageable the the finite human mind.
Insight: Mental accounting influences behaviour - we are more likely to attend an event when we paid for the ticket, rather than getting one for free.
Example: Pro golfers are generally more successful putting to avoid bogey that to achieve a birdie. The best golfers create a separate 'account' for each hole.
Definition: The tendency of people to put funds in different accounts, and focus on the source, and forgetting that the source does not matter.
Example: People vary their strategy at a casino depending on whether they are playing with 'winnings' vs the original amount.
Example: Investors increase risks as they are 'winning', and reduce when they are 'losing'.
Insight: We sort money into categories - for example A for rent, B for food, C for entertainment. This is mental accounting.
Insight: When designing products it can be useful to analyse what current purchases are made by target customers that your product could displace (where would you fit in their mental accounting?).
Definition: The habit of putting money into different 'accounts', which determines how we think about using it.
Insight: The way that we frame accounts influences our behaviour.
Insight: Mental accounting is how we think about money.
Key Insights & Principles
Personal Finance
Money is fungible (interchangeable). When we do mental accounting we violate this principle which can lead to poor decision making.
Mental accounting can be effective if used well - it can help control spending and help us save.
Mental accounting can weaken our self-control when we have vague rules.
Mental accounting can make us overspend when we have 'excess' in an account, or lead us to underspend on things that would be most valuable.
Automate savings and put in accounts that are not readily visible.
Focus on financial objectives rather than source of intended uses for funds.
Regularly review accounts intended and actual use of funds against objectives.
