Mental Accounting

Description

The idea of mental accounting, or “two-pocket theory”, was first introduced by Richard Thaler (2008) as an explanation for why individuals assign a different utility to different asset groups. These asset groups are distinct and non-transferable, and affect our consumption habits in ways that often leave us less financially stable. Despite its irrationality, many of us use mental accounting. We justify this illogical division of assets through the personal value which we place on these certain assets compared to others. For instance, some people leave money sitting in a “vacation savings jar” while credit card debt remains unpaid – an irrational decision, as the credit card debt comes with high interest rates while the money sits dormant accruing no interest. However, because the money is in the “vacation account”, these people does not think to use it to pay the credit card debt.

Example

Imagine you have set a $2 daily coffee budget. In scenario one, you find at the cafe that $2 has fallen out of your pocket, while in scenario two you buy your coffee but then spill it. Would you buy another coffee? In scenario one, most people would because they view the dropped $2 as a loss from their “total budget”, but not their coffee budget. In scenario two, most people would not because they feel like they have already spent their daily $2 on coffee. The economic choice is identical, but people’s decisions changed because of mental accounting.

Further Reading

• http://www.investopedia.com/university/behavioral_finance/behavioral5.asp