Imagine you are saving up for a vacation and set aside a separate account for that goal. You might put money into that account every month and view it as untouchable until your trip. You might set aside a similar account for your retirement, a down-payment on a house, fun money, Christmas gifts, etc. Each bucket of money would have its own use and wouldn’t be interchangeable for another.
Imagine you just received your paycheck, your tax return, won a small lottery, and found $100 dollars on the floor in the same week. You might apply your paycheck towards your normal bills and savings, but the other windfalls might be treated differently. The value of the money is all the same, but how you use it might not be.
Richard Thaler first described this human tendency in his paper Toward a Positive Theory of Consumer Choice (1980). He described mental accounting as a process in which people code, categorize, and evaluate economic outcomes by grouping their assets into any number of non-interchangeable mental accounts. This can cause problems.
Issues with Mental Accounting
Consider a simple example where we have a special account set aside to save money for the purchase of a new home, while at the same time having a significant amount of credit card debt. Every month, most of our money might be used to pay down this high interest debt, but the new home money is separate from this. Money that would otherwise lower our debt and increase our net worth is diverted away to the mentally gated account. In the end, we are worse off.
Another issue with mental accounting is the greater willingness of people to pay up for goods when using a credit card rather than cash. Cash in our pocket might seem like a limited resource, but the credit card limit runs deep.
Another issue is the greater willingness of people to spend windfall profits differently then they would spend normal profits. For example, winning the lottery or receiving an inheritance. If we are not willing to spend our normal income on a boat, why are we so willing to spend a sudden influx of money on it.
Logically, our entire net-worth should be viewed as one interchangeable resource to be allocated towards what brings us the most utility, with no regard for the source of funds or a mentally assigned purpose.
Issues in Investing
Mental accounting causes us to place investments into buckets with and ignore the the underlying correlations between them. For example, we might have a retirement portfolio, a speculative portfolio, a college fund portfolio, and a real-estate portfolio. The optimal investing policy for each portfolio in isolation may not be optimal investing policy when all portfolios are viewed together. A large chunk of our net-worth might be in real estate while a large chunk of our retirement portfolio might be redundantly in REITS.
The rational way to approach investing is to consider each of these portfolios holistically in an overall risk/return context.
Mental accounting is an information-processing bias in which people treat equally sized sums of money differently based on which mental account they are assigned to. This causes issues when our overall financial state is disregarded in order to maximize the use of smaller sub accounts. In other words, missing the forest for the trees.