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Money plays a significant role in our lives, and how we spend it affects our financial well-being. The mental model of Mental Accounting explains how we make money decisions, and how we categorize and label our expenses. It is the psychological process of managing our money, which has a significant impact on our financial behavior. In this blog post, we'll explore this mental model in detail, and how it can help us make better decisions about our finances.
What is Mental Accounting?
Mental Accounting is a concept introduced by Richard Thaler, a behavioral economist and Nobel Prize winner. It refers to the tendency of people to categorize their money into separate mental accounts based on subjective criteria, such as the source of the money, the intended use of the money, or the time period in which the money will be spent. This can lead to irrational financial behavior, such as overspending in one category while underspending in another, or failing to take advantage of opportunities to save or invest.
To illustrate the concept of mental accounting, let's consider an example. Suppose you receive a bonus of $5,000 from your employer. You might mentally categorize this money as "extra" or "discretionary" funds, rather than as part of your regular income. You might then decide to use this money to buy a new TV since you wouldn't normally spend that amount on entertainment. However, if you had received a raise of $5,000 instead, you might not feel the same sense of freedom to spend the money on discretionary items, since it would be part of your regular income.
Mental Accounting in Real Life
Mental accounting affects our financial decisions, even when it is not rational. It can lead to overspending, undersaving, and poor financial planning. For example, people may spend more money on expensive coffee drinks from a coffee shop instead of making their own at home, as they feel that it is an "entertainment" expense rather than a "necessary expense." This can lead to overspending and depletion of their entertainment account.
Similarly, mental accounting can cause people to make irrational investment decisions. For example, people may feel that their investment in a specific company is riskier than investing in a mutual fund. They may be willing to invest in a high-risk, high-return stock, rather than a low-risk, low-return stock, as it is in their "investment" account, rather than their "savings" account.
Using Mental Accounting to Make Better Financial Decisions
By understanding the concept of mental accounting, we can make better financial decisions. We can categorize our expenses, savings, and investments into different mental accounts, and allocate our money accordingly. For example, we can set up separate mental accounts for necessary expenses, entertainment, and savings. This will help us prioritize our expenses and ensure that we have enough money to cover our necessary expenses before spending on entertainment.
Similarly, we can use mental accounting to make better investment decisions. We can allocate our money into different mental accounts based on our risk tolerance and investment goals. For example, we can allocate some money into a high-risk, high-return account for long-term investments, while keeping some money in a low-risk, low-return account for short-term expenses.
The key takeaway from mental accounting is that people tend to think about money in subjective ways, based on their own mental categories and criteria. While mental accounting can be useful for creating budgets and managing money, it can also lead to irrational financial behavior if not used carefully. By being aware of the biases and tendencies associated with mental accounting, we can make better financial decisions and make the most of our resources.
Some prominent figures who have used the concept of mental accounting include:
Warren Buffett, who is known for his disciplined approach to investing and his emphasis on value investing.
Jack Bogle, founder of Vanguard Group and pioneer of low-cost index funds, who encouraged investors to focus on the long-term and avoid the temptation to time the market.
Suze Orman, financial advisor and bestselling author, who emphasizes the importance of having a clear financial plan and understanding one's own financial values and goals.
Sources:
Thaler, R. H. (1999). Mental accounting matters. Journal of Behavioral Decision Making, 12(3), 183-206.
Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47(2), 263-292.
Podcast: How Mental Accounting Can Improve Your Money Habits by Stacking Benjamins
Disclaimer: This is a ChatGPT assisted article by the author