Mental accounting refers to people who tend to separate their money into separate accounts based on a variety of subjective criteria, such as the source of the money and its use.
According to the theory, individuals assign different functions to each group of assets, and often this has an irrational and detrimental effect on their consumption decisions. Many people use mental accounting, but they don't realise that this line of thinking is actually illogical.
For example, sometimes people put aside savings for their vacation or for a new home while they have loans to pay back. In this example, savings and money to pay off debts are treated differently, whereas savings should logically be used to repay loans because interest payments reduce a person's net worth. In other words, it is illogical (and detrimental) to have savings that earn little - or no - interest while at the same time taking out expensive loans.
Instead of saving for a holiday/vacation, it makes more sense to use these funds (and all other available funds) to pay off expensive debts.
It sounds simple enough, but why don't people behave this way? The answer lies in the personal value that people assign to certain assets. For example, they may think that the money saved for a new home or to finance their kids' educations are too important to give up. As a result, this "important" account cannot be touched, even though it may provide an additional financial benefit.
To illustrate the importance of separate accounts with regard to mental accounting, here is a real life example: You are going to buy a sandwich that costs £5 for lunch and while you are waiting in the queue, one of the following things occurs: 1) You see that your pocket has a hole in it and you've lost £5; or 2) You buy the sandwich, but after eating just one bite, you fall and your delicious sandwich ends up on the floor. In both cases (and assuming that you still have enough money), would you buy another sandwich?
Logically speaking, your answer in both scenarios should be the same; the dilemma is whether you should spend £5 more for a sandwich. However, because of the polarisation of mental accounting, this is not always the case.
Most people in the first scenario will not consider lost money as part of their lunch budget because the money had not yet been spent or allocated to this "account". As a result, they would be more likely to buy another sandwich, while in the second scenario the money had already been spent, so they might not buy another sandwich.
Another aspect of mental accounting is that people also treat money differently depending on the source of income. For example, they tend to spend more money that they "found", such as bonuses or work gifts, compared to the money that they typicall expect (like a salary that falls each month). This is another example of how mental accounting can lead to the illogical use of money.
Logically speaking, money should be interchangeable, regardless of its origin. To treat money differently because it comes from a different source violates this logical principle. The source of money should not be a factor that determines its use, regardless of the source, spending represents a decline in your overall wealth.
The mental accounting bias also can affect investing. For example, some investors allocate their investments between a safe portfolio and a speculative portfolio to avoid the negative returns that their speculative investments can have. The problem with such a practice is that despite all of the time and money that the investor spends to separate the portfolio, his fortunes wouldn't have been any different with a larger portfolio.
The key point to take into account regarding mental accounting is that money is "fungible"; no matter its origins or use, it remains the same. You can reduce the frivolous spending of money that you "found", knowing that "found" money is no different than money that you earned by working.
As money is fungible, saving money in a low or no interest account is useless if you have loans to repay. In most cases, interest on your debt will erode the interest you can earn on most savings accounts. It is important to have savings, but sometimes it is better to give up your savings to pay off your debts.
Behavioural finance theory
Flaws in conventional economic theory
Confirmation bias and retrospective
The player's error
Traders' herd behaviour
Overconfidence of traders
Overreactions and availability bias of traders
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