Have you ever decided to treat yourself after receiving an end-of-year bonus, tax refund, or birthday money? In these situations, many of us decide to spend this extra money on something we wouldn’t ordinarily spend our money on, such as splurging on a fancy meal or buying a wishlist item that we’ve been eyeing for a while. While we may normally be much more frugal with our monthly paychecks, we tend to view these unexpected sources of money differently, and therefore spend it differently too.
This is what economists describe as mental accounting: how we tend to value things (in particular money) differently depending on the mental category we assign it to. This goes against the principle in fungibility in economics, which implies that money is interchangeable – i.e. a dollar is still worth a dollar no matter where it is from or how we spend it. In practice, we tend to apply different spending rules to our money depending on the mental labels we have assigned it.1
Richard Thaler, the economist who introduced the idea of mental accounting, conducted experiments on this phenomenon, which illustrate how this bias can occur in our day to day lives. For example, imagine you have decided to go and watch a movie. You spent $10 on your ticket, but when you enter the theater you realise that you’ve lost the ticket. Would you pay $10 to purchase another ticket? When participants were asked this question, less than half of the participants (46%) said that they would purchase another movie ticket. However, imagine the next scenario: you have decided to watch a movie, but as you enter the theater you realise that you have lost a $10 bill. Would you still pay $10 to purchase a ticket? This time, 88% of participants said they would purchase the ticket—almost double compared to the first scenario.2
In theory, we have lost the same amount of money ($10) in both scenarios, so our response should be the same for both questions. However, according to the mental accounting model, we tend to categorize our money into different budgets. In the first scenario, $10 has already been spent from our movie budget, and so spending an additional $10 on the movie would make it seem incredibly expensive. In the second scenario, we attribute the lost $10 cash to a general spending budget instead, so we don’t feel that the lost cash has affected our movie budget, despite the same loss of $10. As we can see, by treating the same value of money differently based on how we have categorized it in our minds, we are more prone to making illogical financial decisions, such as irrational spending or poor investment decisions.