The concept of mental accounting was first identified by the economist Richard Thaler. It shows how we have a natural inclination to organise, evaluate and keep track of our finances. More specifically, it describes our tendency to categorise, compartmentalise and treat money differently depending on where it comes from, where it is kept, or how it is spent.
But why do people do this?
Simply put, mental accounting is about considering the psychology behind peoples’ spending and saving habits and understanding how exactly individuals and/or households organise their money.
In the early 20th century it was somewhat easier to organise our money than it is today. Most people were paid in cash at the end of each week. Therefore, it was a straightforward task to allocate money for different purposes; actual ‘jam jar’ accounting was often used.
A housewife in the early 1920s explained her system to a publication at the time called Women’s Home Companion:
‘I collected eight little cans, all the same size, and pasted on them the following words, in big letters: groceries, carfare, gas, laundry, rent, tithe, savings, miscellaneous.. . . [W]e speak of those cans now, as the grocery can, carfare can, etc.’.
This use of mental accounting, earmarking money for different purposes, can help us to budget, organise and keep track of our money efficiently. In this sense, mental accounting can therefore be a positive thing! A further positive use of mental accounting is to control our spending, for example through:
- Creating physical barriers: Physically splitting money up, separating it into different physical accounts creates a barrier to spending. For example, it might be a hassle to transfer money out of our savings account or there might be a penalty charge for doing so
- Creating mental barriers: At a psychological level, once money is separated out and designated for a particular purpose – even if only virtually by a banking app – we may feel committed to that designation and reluctant to change it. For example, we might be hesitant to spend money we have already mentally allocated to paying our rent on buying a new car. Challenger banks are designing for this and assigning available funds in a customer’s current account for bills and other scheduled payments, to help make sure customers can pay monthly outgoings.
Mental accounting can therefore be useful to help ensure we have the funds for necessities like bills or can save for specific goals.
However, mental accounting also means we can behave in sub-optimal ways. Where ‘rational’ behaviour might treat a pound as a pound, regardless of where it comes from, most people tend to treat money differently depending on where it has come from. For example, ‘found’ money will tend to be regarded differently from earned money. This means we tend to spend gains – particularly unexpected gains – from gambling wins, bonuses, inheritances and other gifts differently to how we might spend the money we have earned:
- Profligate spending or gambling of money won: We tend to spend ‘won’ money, money we didn’t expect to have, such as a gift, or tax rebate or prize wins, in a very hedonic or profligate way. For example, people are more likely to gamble with money they have won than money they have earned or inherited
- Simultaneous borrowing and saving: Mental accounting also helps explain an aversion to using savings to pay off debt. For example, we might have a costly loan or credit card debt, despite holding savings that could pay off part or even all that debt. Indeed, one study of US households found that 90% of credit card borrowers simultaneously hold some savings, and that a third even had over a month’s worth of income in savings. Another US study found that almost one in five people who took out high cost loans such as payday loans did so without fully emptying their savings.[1]
- Worthy spending of sentimental money: We often treat money differently when it comes from a sentimental source. For example, it seems morally and emotionally wrong to many people to use a sum of money that has sentimental origins – perhaps given to us by a close relation who has passed away – to pay off debt, pay bills or even invest it in high return stocks. We often want to do something significant or memorable with it, such as using it to fund a holiday of a lifetime or to set up a charity.
Mental Accounting Illustrated
Earmarking money into different accounts for different purposes has numerous benefits, sometimes they can be too rigid. This flaw in mental accounting is perfectly illustrated in this scene from US TV series Curb Your Enthusiasm:
Here the show’s protagonist Larry has just received an invitation to friend Simon’s lavish birthday party. Larry, recalling that he lent Simon $10,000 a month ago, decides to challenge Simon on his mental accounting… Simon’s rigid earmarking of the money leaves Larry feeling miffed!
So, what does this all mean?
Understanding spending, saving and investment behaviours through the lens of mental accounting can shed light on a lot of money management decisions. For researchers, knowing that consumers will tend to view money that comes from different sources (e.g. tax rebate, earnings, bonuses, or birthday money) differently can be incredibly insightful for understanding why they may make seemingly irrational financial decisions, such as remaining in debt despite large savings. This understanding feeds through into initiatives that aim to help consumers better manage their finances. For example, the monthly budget planner app iSaveMoney helps users divide their earnings into categories and encourages category-based goal setting. Challenger banks, such as Monzo, are also adopting this kind of categorisation technique; its salary sorting function encourages greater organisation of personal finances. Being better financially organised and setting clearly defined goals can help consumers avoid the traps associated with mental accounting.
NEXT IN THE SERIES: Every three weeks The Behavioural Architects will put another cognitive bias or behavioural economics concept under the spotlight. Our next article features the concept of status quo bias.
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PREVIOUS ARTICLES IN THE SERIES:
System 1 & 2
Heuristics
Optimism bias
Availability bias
Inattentional blindness
Change blindness
Anchoring
Confirmation Bias
Framing
Loss aversion
Reciprocity
Hot cold empathy gaps
Social norms part 1
Social norms part 2
Commitment bias
Affect Heuristic
Paradox of Choice
[1] Abigail Sussman and Rourke Liam O’Brien, “Saving for a Purpose: The Financial Consequences of Protecting Savings,” Working paper, December 2014.
