Mental Accounting

Understanding the mental accounting helps with spending, budgeting and investing decisions. Mental accounting means that people mentally divide their assets and income into buckets. Depending on the mental account, vastly different decisions are made regarding the money. Even though money should be exchangeable. Scientists mainly seem to be interested in trying to predict and explain behavior, so they do not necessarily label mental accounting as a negative thing. There can indeed be some positive aspects to mental accounting. However, when a mental accounting decision has a negative impact on current or future net worth and there appears to be no rational motive for it, it is a mental accounting error.

The classic example of a mental accounting error is when a person maintains a large credit balance at 12% while also maintaining an even larger checking account balance earning 1% that could be used to eliminate the debt. For some, even if they are aware of the money that could be saved, they may choose not to do so because the checking account is viewed as an emergency fund that cannot be tapped. For other, the high checking account balance in isolation may make them feel wealthy and a reduction of the account would make them feel less so.

Other mental accounting errors are extremely subtle and even the people who are experts in this field admit to making such errors. Here are some more mental accounting errors people make.

  • Treating each account separately. We used to diversify each account individually instead of across all accounts. We did this because we did not want any particular account to have a high volatility and because an individual account statement would otherwise look too concentrated in a couple of positions. This is definitely mental accounting, separating money based on account. However, if the accounts are similar in nature, then this is usually harmful to net worth for no reason. It results in higher fees since the position sizes are smaller. So some people need to train to avoid looking at each individual account in isolation and instead look at the total portfolio across all accounts. This saves money.
  • Treating fees separately from all other money. Many people have a real attitude about fees. Anything labeled as a fee is treated as an evil to be avoided at all cost. Our emotional side gets worked up about fees as well, but we have often found it is cheaper to pay them than the alternatives we choose. For example, suppose you find yourself in need of cash and the only nearby ATM is not your bank, so you will have to pay a €2 ATM fee. If you then drive 5 km to your bank to save the €2 fee, you probably will spend more than €1 in gas on the 10 km trip. If you have a newer vehicle, you also probably incurred way more than €2 in depreciation and wear and tear on the vehicle. We used to spend €5 elsewhere to save €2 on ATM fees because we hated the fees. The fact that “€2.00 Terminal Fee” is immediately printed on the ATM receipt highlights the fee, while the fact that the gas and maintenance outflows come later obscures the alternative costs. ATM fees were just the tip of the iceberg. We learned to be careful about all sorts of fees and their alternative costs.
  • Treating the same amount of money differently depending on context. We often tend to view a particular amount of money based on the surrounding context. For example, if a coffee maker that we are interested in purchasing is always seen selling for €10 and we suddenly find it selling at a particular store for €5, we spend time and effort to obtain it at that price. After all, it is 50% off. On the other hand, if a dining room set normally sells for €999 and we see it for €979, we are unimpressed because the percentage different is small. Yet, €20 is still €20 regardless of context. The biggest lesson here for us was not to disregard comparatively small savings when making large purchases.

Which mental accounting error did you observed?

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