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Mental accounting refers to the different values people place on money, based on subjective criteria, that often has detrimental results. 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 therefore are prone to irrational decision-making in their spending and investment behavior.
Richard Thaler, currently a professor of economics at the University of Chicago Booth School of Business , introduced mental accounting in his paper "Mental Accounting Matters," which appeared in the Journal of Behavioral Decision Making.
He begins with this definition: "Mental accounting is the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities. Underlying the theory is the concept of fungibility of money. To say money is fungible means that, regardless of its origins or intended use, all money is the same. To avoid the mental accounting bias, individuals should treat money as perfectly fungible when they allocate among different accounts, be it a budget account everyday living expenses , a discretionary spending account, or a wealth account savings and investments.
They also should value a dollar the same whether it is earned through work or given to them. However, Thaler 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 over-payment 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. Richard Thaler won the Nobel Memorial Prize in Economic Sciences for his work in identifying individuals' irrational behavior in economic decisions.
Individuals don't realize the mental accounting line of thinking seems to make sense, but is in fact highly illogical. 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.
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.
Put in this way, the solution to this problem seems straightforward. Nonetheless, 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. 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 financial crisis.
People also tend to experience the mental accounting bias in investing as well. 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 from 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 out the portfolios from one another. Mental accounting often leads investors to make irrational decisions. 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.
By using Investopedia, you accept our. Your Money. Your Practice. Popular Courses. Economics Behavioral Economics. What is Mental Accounting? Key Takeaways Mental accounting, a behavioral economics concept introduced in by Nobel Prize-winning economist Richard Thaler, refers to the different values people place on money, based on subjective criteria, that often has detrimental results. Mental accounting often leads people to make irrational investment decisions and behave in financially counterproductive or detrimental ways, such as funding a low-interest savings account while carrying large credit card balances.
Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. Related Terms Rational Behavior Definition Rational behavior is a decision-making process that results in an optimal level of benefit or utility for an individual.
Behavioral Finance Definition Behavioral finance is an area of study that proposes psychology-based theories to explain market outcomes and anomalies. Loss Psychology Definition Loss psychology refers to the emotional side of investing, namely the negative sentiment associated with recognizing a loss and its psychological effects.
Rational Choice Theory Definition Rational choice theory says individuals rely on rational calculations to make rational choices that result in outcomes aligned with their best interests.
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Economics can be distinguished from other social sciences by the belief that most behavior can be explained by assuming that agents have stable, well-defined preferences and make rational choices consistent with those preferences in markets that clear. The anomalous empirical evidence on consumption falls into roughly two categories. First, consumption appears to be excessively sensitive to income. Over the life cycle, the young and the old appear to consume too little, and the middle-aged consume too much. Also, year-to-year consumption rates are too highly correlated with income to be consistent with the model. Second, various forms of wealth do not appear to be as close substitutes as the theory would suggest.
Anomalies: Saving, Fungibility and Mental Accounts
Mental accounting or psychological accounting attempts to describe the process whereby people code, categorize and evaluate economic outcomes. People budget money into mental accounts for expenses e. People are presumed to make mental accounts as a way to manage and keep track of their spending and resources. Understanding the flaws and inefficiencies of mental accounting is essential to making good decisions and reducing human error. People can even have multiple mental accounts for the same kind of resource. A person may use different monthly budgets for grocery shopping and eating out at restaurants, for example, and constrain one kind of purchase when its budget has run out while not constraining the other kind of purchase, even though both expenditures draw on the same fungible resource income. In mental accounting theory, framing means that the way a person subjectively frames a transaction in their mind will determine the utility they receive or expect.
Anomalies: Saving, Fungibility, and Mental Accounts
Saving, Fungibility, and Mental Accounts