The term ‘Mental Accounting’ was first coined by the Nobel prize winning economist Richard Thaler in 1999, in line with the work done by Daniel Kahneman and Amos Tversky, the fathers of Behavioural Economics. Mental accounting occurs when people categorise their money into different ‘mental’ or imaginary accounts to track their finances easier. People usually rely on Mental Accounting as a shortcut or trick to control their impulse to spend all their money. By putting some of it aside and labelling it mentally as being for another purpose, you can budget your income better and keep your spending in control.
Categorising your money into different mental accounts will cause you to miss the fact that money is interchangeable and may restrict you from utilising your own money for a better use. For example, you may be saving funds in your bank account for a goal which is 5+ years away, while having an overdue credit card balance on which you pay a huge rate of interest. In your mind, the money in the bank account is for that goal only, and so you do not use it to repay your credit card debt.
Another kind of mental accounting bias occurs when you treat money differently depending on where it has come from. For example, you spend your annual performance bonus or income tax refund on buying luxury gadgets, vacations, but you are otherwise stingy and careful with your regular salary. This can also affect your investment decisions. Say you invested Rs. 100 in a stock and gained 20% or Rs. 20 on it. You may now take higher risk on this Rs.20 of gains when reinvesting it as you may consider it to be ‘free’ money. But money is fungible, so your gains are the same as money in your savings bank account.
If you have a more organised financial planning process, you would not need mental accounting and you would optimise your finances better by knowing exactly how much you need to set aside for your goals and how much you can spend. Also, it may be a good idea to save or invest unexpected income you have received (at least a significant portion) so that you can achieve your financial goals faster. If it is difficult for you to plan your finances without mental accounting, you can take the help of a financial advisor or use an app providing financial guidance which helps you overcome your behavioural biases.
