what is mental accounting 
mental accounting refers to the different values a person places on the same amount of money based on subjective criteria mental accounting is a concept in the field of behavioral economics developed by economist richard h thaler it contends that individuals classify funds differently and are therefore prone to irrational decision making in their spending and investment behavior 1understanding mental accountingin his 1999 paper mental accounting matters richard thaler currently a professor of economics at the university of chicago booth school of business defined mental accounting as the set of cognitive operations used by individuals and households to organize evaluate and keep track of financial activities 23underlying the theory is the concept of the fungibility of money to say money is fungible means that regardless of its origins or intended use all money is the same 14to avoid the mental accounting bias individuals should treat money as perfectly fungible when they allocate it among different accounts they also should value a dollar the same whether it is earned through work or given to them 14thaler observed that people frequently violate the fungibility principle especially in a windfall situation take a tax refund getting a check from the irs is generally regarded as found money something extra that the recipient often feels free to spend on a discretionary item but in fact the money rightfully belonged to the individual in the first place as the word refund implies and is mainly a restoration of money in this case an overpayment of tax not a gift therefore it should not be treated as a gift but rather viewed in much the same way that the individual would view their regular income 1to avoid mental accounting bias people should value every dollar they receive in the same way whether it is earned through work or given to them don t think of a tax refund as a windfall suitable for splurging example of mental accountingthe mental accounting line of thinking seems to make sense but is in fact highly illogical for instance some people keep a special money jar or similar fund set aside for a vacation or a new home while at the same time carrying substantial credit card debt they are likely to treat the money in this special fund differently from the money that is being used to pay down debt in spite of the fact that diverting funds from the debt repayment process increases interest payments thereby reducing their total net worth broken down further it s illogical and in fact detrimental to maintain a savings jar that earns little or no interest while simultaneously holding credit card debt that accrues double digit figures annually in many cases the interest on this debt will erode any interest you could earn in a savings account individuals in this scenario would be best off using the funds they have saved in the special account to pay off the expensive debt before it accumulates any further the solution to this problem seems straightforward yet many people do not behave in this way the reason has to do with the type of personal value that individuals place on particular assets many people feel for example that money saved for a new house or a child s college fund is simply too important to relinquish even if doing so would be the most logical and beneficial move so the practice of maintaining money in a low or no interest account while also carrying outstanding debt remains common professor thaler made a cameo appearance in the movie the big short to explain the hot hand fallacy as it applied to synthetic collateralized debt obligations cdos during the housing bubble prior to the 2007 2008 financial crisis 5mental accounting in investingpeople also tend to experience mental accounting bias when investing for instance many investors divide their assets between safe portfolios and speculative ones on the premise that they can prevent the negative returns from speculative investments impacting the total portfolio in this case the difference in net wealth is zero regardless of whether the investor holds multiple portfolios or one larger portfolio the only discrepancy in these two situations is the amount of time and effort the investor takes to separate the portfolios from one another borrowing from daniel kahneman and amos tversky s groundbreaking theory on loss aversion thaler offers this example an investor owns two stocks one with a paper gain the other with a paper loss the investor needs to raise cash and must sell one of the stocks mental accounting is biased toward selling the winner even though selling the loser is usually the rational decision due to tax loss benefits as well as the fact that the losing stock is a weaker investment the pain of realizing a loss is too much for the investor to bear so the investor sells the winner to avoid that pain this is the loss aversion effect that can lead investors astray with their decisions 4