Mental Accounting
Candlefocus EditorTo understand the concept of mental accounting, it is helpful to imagine it as a bank of three accounts: a budget account, a discretionary spending account, and a wealth account. In this scenario, the budget account would include everyday necessities such as groceries and gasoline. By using mental accounting, our hypothetical individual might think of this as “separate” from other accounts, so that it is not to be touched for impulsive purchases. The discretionary spending account could be used for small luxury items such as restaurant meals, while the wealth account would be used for long-term investments and savings.
In an ideal world, the individual would transfer money between the accounts as needed so that their financial goals remain on track. Unfortunately, mental accounting often leads to people making irrational decisions. For example, they may feel an emotional attachment to money in the wealth account and be unwilling to transfer it to the budget account to pay for everyday expenses, despite the fact that the wealth account isn’t likely to yield high enough returns to offset the missed opportunity.
If individuals want to maximize their financial goals and make sound decisions, they need to actively manage their mental accounting. To reduce the risk of making irrational decisions, individuals need to understand that all money is equal—whether it’s funneled into the budget account, discretionary spending account, or wealth account. This way, individuals can allocate money where it’s wanted most and avoid the financial hardship of carrying large credit card balances. As the concept of mental accounting becomes more widely known, individuals and businesses alike can strive to make decisions that maximize the value of their money.