What is Mental Accounting Bias?
Mental accounting is a process that individuals use to assign subjective values to their money. However, these values go against the accepted economic principles. Mental accounting is a concept that comes from behavioural economics. Often, people tend to place varying values on the same amount of money based on their preferences. However, this process can lead to losses.
Mental accounting leads to a behavioural bias that can influence the decisions that individuals make. It is also known as the “two-pocket theory”. In mental accounting, people tend to classify their money and put them in mental accounts. The classification may occur on a different basis, such as where the money comes from or how they intend to use it.
How does Mental Accounting Bias work?
The concept of mental accounting bias comes from the work of an economics professor, Richard Thaler. He defined mental accounting as “the set of cognitive operations used by individuals and households to organize, evaluate and keep track of financial activities”. Therefore, mental accounting works through the classification or categorization of money that individuals make based on their beliefs.
Mental accounting bias influences individuals to make irrational decisions when it comes to their finances. Once they set aside money for a specific purpose, they fail to consider any drawbacks of using it. Similarly, they fail to consider their decisions as a part of an overall goal. Furthermore, individuals perceive losses and gains in different terms. All of these perceptions depend on the situation in which they are.
Mental accounting is also closely related to the concept of the fungibility of money. This concept suggests that money is the same regardless of where it comes from or how individuals intend to use it. However, mental accounting goes against it because individuals differentiate between money based on these factors. By understanding this, individuals can also avoid the influence that mental accounting has on their decisions.
How does Mental Accounting apply to investors?
Mental accounting bias is prevalent for investors. Some investors like to classify their portfolios into two categories. One includes safe stocks that they can use as a substitute for any losses from the other category. The other classification is speculative portfolios that investors use to make high-risk investments.
Mental accounting can lead to investors taking irrational decisions. When investors compare losses and profits, they end up perceiving both differently. Although both may have the same monetary values, investors tend to make categories for each based on a mental account. Therefore, it leads investors to think in relative terms rather than viewing decisions in absolute terms.
How to avoid Mental Accounting Bias?
Mental accounting can occur for all individuals. However, it is still avoidable. Individuals that demonstrate mental accounting can use deliberate planning to break bad financial habits. These may include creating budgets or making plans for any unexpected income or gains they receive.
Furthermore, individuals that suffer from mental accounting can also look at the whole picture. This way, they can perceive decisions in absolute terms rather than relative terms. Using all of these techniques, individuals can avoid the adverse effects of mental accounting bias.
Mental accounting bias is when individuals assign subjective values to their money. These values may come from how they perceive their money. Mental accounting bias can cause several problems and result in losses for individuals. It is also common for investors to illustrate such behaviour. However, mental accounting bias is avoidable through proper planning and deliberate decision-making.