Mental accounting¶
Shelly Deng & Brandon McGorty
In behavioral economics, mental accounting refers to the set of rules describing how individuals value and spend money based on the money’s origin and on how one labels the money (Thaler, 1985, 1999). For example, people may treat money intended for one category of purchases differently than money intended for another category. In evaluating and making financial decisions using mental accounting, people evaluate between options within a specific context and in relation to a reference point. With context in mind and using a reference point, people place money into different mental buckets. Specifically, individuals set up decision frames for money in different buckets, and for each, they evaluate different outcomes as they are relevant to the reference or neutral outcome. Since people put a mental label to money, the principle of fungibility, which states that any unit of money is substitutable, is violated.
Mental accounting examples are prevalent throughout our daily lives. To give a simple example, suppose that John spends no more than $30 for a bottle of wine normally, but since he won the lottery of $45 this month, he decided to make a one-time purchase of a bottle that costs $45. This example is consistent with the idea that there exists different mental accounts for hard-earned money (i.e. from his salary) and for windfall money (i.e. for the lottery). This difference in labeling results in him spending money in a manner that is atypical of his normal spending behavior.
With a basic introduction to mental accounting, the rest of this chapter will dive into mental accounting a little deeper. Specifically, mental accounting involves three components: perception and evaluation, budgeting, and choice bracketing. The first component, perception and evaluation, is concerned with how individuals perceive outcomes and evaluate decisions. The second component, budgeting, involves assigning different decisions to specific mental accounts. Finally, the third component of choice bracketing is concerned with evaluation of mental accounting and the frequency in which accounts are balanced. In this chapter, we will aim to understand these three components of mental accounting. We will end the chapter summarizing important points and review their implications, in hope to shed light on how we may use mental accounting to our advantage and combat irrational financial pitfalls.
First Component: Perception and Evaluation¶
The way individuals perceive outcomes and evaluate decisions plays an important role in mental accounting. To understand the perception and evaluation component of mental accounting, we must understand how gains and losses are viewed and how individuals perform hedonic editing to maximize utility. Additionally, we need to understand transaction theory and how time affects financial decisions.
First, we will use the value function from prospect theory to model the utility. The value function has three key features: gains and losses are thought of in relation to a reference point (usually the status quo), the value function is piecewise where the gain function is concave and the loss function is convex, and the value function adheres to loss aversion principles, such that the slope for losses is steeper than the slope for gains.
Given a set of outcomes within the same mental account, individuals tend to perform hedonic framing to maximize utility (or pleasure) although there are exceptions to the hedonic framing hypothesis. Generally, there are four principles of hedonic framing. First, individuals tend to segregate gains, which makes sense because the gain function is concave. Indeed, 64% of research participants believed that someone who won two lottery tickets with the total value of $75 would be happier than someone who won a single lottery worth $75 (Thaler, 1985, 1999). Second, individuals integrate losses. Because the loss function is convex, losing $30 and then losing $20 is less preferred than losing $50 at once. In fact, credit cards may help reduce the mental cost of spending by directly integrating spending/losses (Thaler, 1985). Third, people tend to integrate smaller losses with larger gains. By combining smaller losses with larger gains, individuals can view the two outcomes as a single smaller gain, and this allows them to reduce the psychological penalty of loss aversion. Finally, people tend to segregate small gains from larger losses. For example, the majority of research subjects believed that Person A who has to pay $175 to repair a car would be less happy than Person B who has to pay $200 to repair a car but who won $25 from an office football pool (Thaler, 1985). Intuitively, this makes sense because such segregation allows Person B to see the small winning as a “silver lining”. From the value function, this also makes sense since the gain function is the steepest at the origin. Combining small gains with larger losses would reduce the magnitude of displeasure. However, this reduction is less than the gain of utility from segregation of the smaller gain from the larger loss.
Utility affects how individuals evaluate financial decisions. When making a purchase, consumers obtain acquisition utility as well as transaction utility. Acquisition utility is the measure of the value of the good relative to the price, and transaction utility is the measure of the value of the good as determined by the perceived value of the “deal” (Thaler, 1999). Thus, individuals may make irrational purchases simply because they are good deals. For example, many people end up buying items that they barely use. On the flip side, individuals also may give up buying an item even if it makes them better off because it has negative transaction utility. To illustrate, consumers typically have different reference price points for goods at different contexts. For example, consumers are typically willing to pay around $1 at a convenience store but $3.50 at Disney World for a standard-sized water bottle. With these reference price points in mind, they may not purchase the water for $2.50 at a convenience store even if they are really thirsty.
Finally, the concept of time plays a role in how people make and evaluate financial decisions. First, advance purchases are considered investments, which allows consumers to decouple payment and consumption. Since payment is made at an earlier time, consumers do not have to bear the psychological pain of paying, thus allowing them to enjoy their goods as if they are free. Examples of advance purchases include buying a case of wine, paying for time-share properties, and the use of credit cards.
Sunk cost, which pertains to financial decisions previously made, connects to advance purchases. To give an example, people exhibit the sunk cost effect when they sit through a movie that they dislike, simply because of the money that they paid to see it. Sunk cost has implications for mental accounting. Specifically in a research study by Kahneman and Tversky, subjects are less likely to buy a second ticket to a play after they lost their ticket than to purchase the ticket for the first time but after losing the same amount of money (1984). In either case, the consumer’s overall wealth will decrease by the same amount in both scenarios if they decide to watch the play. However, because consumers have different buckets and budgets for different outcomes, the sunk cost effect is activated, and they become more inclined to purchase a ticket in one scenario than the other.
Second Component: Budgeting¶
Mental accounting also influences how people budget. Budgeting happens in three ways or levels. First, expenditures are grouped into budgets. For example, it is common to have separate budgets for food, housing, entertainment, and more. Second, wealth is allocated into different mental wealth accounts, and some common ones include checking, saving, and rainy-day. Finally, income is divided based on source. For example, it can be regular income (i.e. salary) or windfall (i.e. winning the lottery). The labeling of money can thus reduce flexibility in how money is spent.
The grouping of expenditure into budgets involves two steps: booking and posting. First, the consumer must be aware of or register the expense. Second, the consumer must then classify that expense into the proper account. However, this booking and posting process inherently has a blindspotted pitfall: small expenditures tend to fall into the cracks and go unnoticed. For example, paying $0.50 in tip for a coffee may look innocent, but repeated enough, this can sum to a large amount. Businesses thus often may take advantage of such phenomenon to trick consumers into spending money, and examples in real life include the purchasing of iCloud storage or subscribing to Spotify. While individuals may budget expenditures to reduce spending (i.e. setting a maximum on a certain type of goods), being mindful of small expenses to ensure booking and posting of all expenses is necessary for effective reduction of spending.
Wealth is often automatically placed into different accounts. People have different spending habits for different wealth accounts, and certain allocation of wealth allows individuals to enforce self-control in their expenditure. For example, people typically have little reservation spending current assets such as cash and checking accounts. Then they have increasing reservation about touching the funds in the current wealth bucket (saving accounts, stocks, bonds, mutual fund), home equity bucket, and future income bucket.
Mental accounting has implications for intertemporal choices. For example, suppose there are two scenarios: In the first, consumers have the choice of receiving $10 today or $15 in a year. In the second, they have the choice of receiving $100 or $150 with the same timeline. Participants tend to choose differently for the two scenarios, and researchers have tried to explain this using mental accounting (Shefrin & Thaler, 1988; Loewenstein & Thaler, 1989). The participant might put that gain into the mental “saving” account when the amount is large but in the mental “checking” account when the amount is small. Effectively, this means that they would be foregoing consumption when the amount is small but foregoing interest when the amount is large. In that case, the consumer may wish to receive $10 now in order to have the money for spending but choose the $150 option because $50 is more than the interest that one can earn from $100 in two weeks.
Additionally, classifying money into different mental wealth accounts (i.e. saving, checking) may enable people to save more. Since people are less likely to spend from the “home equity” or “future income” buckets, placing money in these buckets may help them save. Specifically, this might mean buying houses as investment and signing on job offers that give increasing salaries rather than a flat rate over some number of years.
Finally, income is labeled based on its source, and people may have different spending rules for money from different sources. Typically, people match their spending criterion with how easy they obtain the income. For example, people might be less inclined to spend on a luxurious vacation using their salary money, but they are more likely to do so if the money came from a lottery win. This labeling of money shows that people do not have strict rules that govern how they spend money.
Third Component: Individual vs. grouped decisions¶
When analyzing financial decisions made by individuals it’s important to know whether they made decisions one at a time or grouped together in predicting their consumer outcomes. According to the theory of fungibility, money should have the same value no matter what it’s being used for. We see in many ways this becomes false when we look at mental accounting. People often put their costs into different groupings or categories which violates this principle because it puts a different value on money depending on what it’s being spent for. For example, an individual may have different expenses laid out for housing, food, or clothes and are willing to put different budgets on each when in reality the money all has the same value. When these different groupings are made, there are different reference points for spending which leads to people spending more even though they feel well organized.
When individuals establish groupings to their spending, such as money allocated for housing or electric bills, they begin to spend in a group-specific way. Depending on the framing of each group, people are willing to spend more on things when they fit into a category with a higher budget.
The value of gains and losses and how we frame decisions moving forward is very important in our financial decisions. When analyzing the framing of gains and losses it is very important to consider the value function. This shows how events are perceived and coded in decision making. We see that the value function is defined by a certain reference point when analyzing gains and losses. For example, when individuals have larger losses paired with small gains they often feel better about the situation, as discussed above. An example of this would be with investing. Say an investor lost $5,000 but also made $1,000 they would feel better than just losing $4,000. Even though they have lost the same amount of money they feel better about the first situation because they are framed to appreciate gains. Likewise, people often cancel out losses when they can pair them with large gains.
The article “Individual Differences in Mental Accounting’’ by Stephan Muehlbacher and Erich Kirchler presents three studies that apply a Likert-type scale to assess how much individuals engage in mental accounting practices. Their work showed that when individuals used categories for how they spend, a loss in a certain category, like housing for example, led to less spending in that category in the future compared to spending without categories. Also, when an individual has two separate gains, they often look at the value as greater than the actual combined value is. Likewise, when people have already been losing a lot, a little more loss tends to not seem as serious as that same value of a loss without prior losing.
Myopic loss aversion¶
An important concept related to this topic is myopic loss aversion. To understand myopic loss aversion, we must first understand loss aversion as a whole. Loss aversion refers to the tendency to prefer to avoid potential losses versus obtaining gains. In other words, a person would avoid risking $70 in order to potentially win $50. This seems similar to the concept of risk aversion with the main difference being that with loss aversion, the utility of a monetary payoff is determined by previous experiences. Myopic loss aversion refers to the theory that the more frequently we evaluate our portfolio, the more likely we are to observe a loss and subject ourselves to loss aversion (Thaler, 1999). This means that when individuals analyze their money and put labels on what it’s spent on, they become more likely to spend less in categories where there is risk of losing money based on past experiences.
When you take these individuals, who are loss-averse, we see that they are more willing to take risks if many bets are paired together versus if they consider each on their own. This relates well to the theories previously discussed because we know that individuals tend to view losses as less aversive if they’re paired with gains and also tend to feel less bad about a small particular loss when they’ve already been losing. Gneezy and Potters showed in a 1997 study that individuals are more risk seeking when they are shown 30-year return rates when investing versus when they’re shown 1-year return rates. This is because individuals see the gains clumped into one final gain and the losses along the way don’t seem as significant versus losses in the short run that are more severe if they aren’t paired with big gains.
Conclusion¶
The implications of these mental accounting principles are important. How we value and spend our money is vital to our long-term financial well-being. It’s important to understand the ways people tend to value money and how we can better act to fully maximize our finances. By furthering their knowledge on money spending practices, people can be better prepared to be financially intelligent with their money and maximize its potential.
References¶
Muehlbacher, S., & Kirchler, E. (2019, December 3). Individual Differences in Mental Accounting. Frontiers. https://www.frontiersin.org/articles/10.3389/fpsyg.2019.02866/full.
Thaler, R. (1985). Mental Accounting and Consumer Choice. Marketing Science. https://www.jstor.org/stable/183904?seq=1.
Thaler, R. H. (1999). Mental Accounting Matters. Journal of Behavioral Decisions Making. https://people.bath.ac.uk/mnsrf/Teaching 2011/Thaler-99.pdf.
Thaler, R. H. (2017, October 9). Integrating Economics With Psychology . Kungl. Vetenskaps Akademien. https://www.nobelprize.org/uploads/2018/06/advanced-economicsciences2017.pdf.
Kahneman, D. and Tversky, A. ‘Choices, values, and frames’. The American Psychologist, 39 (1984), 341-350. Keren, G. ‘Additional tests of utility theory under unique and repeated conditions’. Journal of Behavioral Decision Making, 4 (1991), 297-304.
Thaler R. H. “Mental Accounting and Consumer Choice”, Marketing Science, 4 (1985), 199-214.
Loewenstein, George, and Richard H. Thaler. 1989. “Anomalies: Intertemporal Choice.” Journal of Economic Perspectives, 3 (4): 181-193.
Shefrin, Hersh, and Richard H. Thaler, “The Behavioral Life-Cycle Hypothesis,” Economic Inquiry, October 1988, 26, 609-643.