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CMC Senior Theses

Mental accounting as a mediator of self-control in consumer decision making.

Lauren E. Yeske , Claremont McKenna College Follow

Graduation Year

Spring 2012

Document Type

Campus Only Senior Thesis

Degree Name

Bachelor of Arts

Gabriel I. Cook

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© 2012 Lauren E. Yeske

Mental accounting is a technique for asserting self-control in the face of consumption decisions, functioning as a categorization system for income and expenses. A body of evidence supports the concept that consumers are driven by perception and emotion, not rational economic thought. Mental accounting is subject to the effects of cognitive biases, leading to imperfect financial behavior. In the following paper, I present a proposal for three consecutive experiments designed to investigate the influence that advanced planning (the formation of mental budgets) and unexpected financial shocks (windfalls) can have on our use of mental accounting to regulate spending. The dependent variable is a dollar measure of how much consumers indicated they are “willing to pay” (WTP) to hypothetically purchase a typical good. The experiments share an intertemporal manipulation of a monthly budget creation task. Experiment one investigates the combined effects of positive and negative windfalls and budget creation on WTP. Experiment 2 explores boundary conditions of timing on loss aversion by manipulating the length of the time period that separates a negative windfall from the WTP task. Experiment 3 focuses on one time period, manipulating wording of a negative financial shock to focus on framing effects. The three experiments, if carried out, should reveal significant effects on WTP, suggesting that manipulations of framing and timing can lead to inconsistent spending behaviors even in the presence of a self-control tool (the mental budget).

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Yeske, Lauren E., "Mental Accounting As a Mediator of Self-Control in Consumer Decision Making" (2012). CMC Senior Theses . 421. https://scholarship.claremont.edu/cmc_theses/421

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Mental Accounting and Saving Behavior

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Perspectives on Mental Accounting: An Exploration of Budgeting and Investing

Financial Planning Review, Vol. 1, Issue 1-2, March-June 2018

Posted: 12 Nov 2019

C. Yiwei Zhang

University of Wisconsin - Madison

Abigail B. Sussman

University of Chicago - Booth School of Business

Date Written: September 19, 2018

This article provides an overview of recent advances in the literature on mental accounting within the context of consumer financial decision‐making. We first discuss the categorization process that underlies mental accounting and the methods people use to categorize funds. We then highlight some of the notable work that examines how mental accounting influences budgeting, spending, and investment decisions. The article concludes by proposing an agenda for future research, focusing on current gaps in our knowledge and promising areas to explore. Full Text Available Here: https://doi.org/10.1002/cfp2.1011

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C. Yiwei Zhang (Contact Author)

University of wisconsin - madison ( email ).

HOME PAGE: http://www.yiwei-zhang.com

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Role of Mental Accounting in Personal Financial Planning: A Study Among Indian Households

• Research in Progress
• Published: 27 November 2022
• Volume 67 , pages 568–582, ( 2022 )

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• Mousumi Singha Mahapatra   ORCID: orcid.org/0000-0003-3773-4633 1 ,
• Jayasree Raveendran 2 &
• Ram Kumar Mishra 1  

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The mental accounting process of an individual plays an important role in financial decision-making. Little is known, especially in the Indian context, about individual differences in mental accounting and its influence on their financial planning. The study aims to understand the role of the mental accounting system of individuals in financial decisions. The authors also explore the influence of the individual’s cognitive ability in financial decision-making and name the antecedent as financial cognition. Partial least square structural equation modeling has been used to analyze the data. The analysis of the data supports the mediating role of mental accounting between financial cognition and personal financial planning. The result establishes the fact that the individuals’ financial cognitions influence the mental accounting process and reinforce the role of psychological processes that drive financial decisions. The study would be helpful to financial planners in customizing personal financial planning with the understanding of financial cognition and the mental accounting process and would be helpful to the financial professionals and advisors in understanding the influence of mental accounting in saving and expenditure patterns.

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Acknowledgements

The authors are grateful for the support of all the survey participants for their valuable response and deeply thankful to the reviewers for their precious comments.

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All authors contributed to the study conception and design. Material preparation, data collection, and analysis were performed by Dr. Mousumi Singha Mahapatra, Dr. Jayasree Raveendran, and Prof. Ram Kumar Mishra. The first draft of the manuscript was written by Dr. Mousumi Singha Mahapatra, and all authors commented on previous versions of the manuscript. All authors read and approved the final manuscript.

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Mahapatra, M.S., Raveendran, J. & Mishra, R.K. Role of Mental Accounting in Personal Financial Planning: A Study Among Indian Households. Psychol Stud 67 , 568–582 (2022). https://doi.org/10.1007/s12646-022-00683-6

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Received : 21 June 2021

Accepted : 03 May 2022

Published : 27 November 2022

Issue Date : December 2022

DOI : https://doi.org/10.1007/s12646-022-00683-6

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What Is Mental Accounting?

Understanding mental accounting, example of mental accounting, mental accounting in investing.

• Frequently Asked Questions

The Bottom Line

• Behavioral Economics

Mental Accounting: Definition, Avoiding Bias, and Example

Mental accounting refers to the different values a person places on the same amount of money based on subjective criteria.

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 are therefore prone to irrational decision-making in their spending and investment behavior.

Key Takeaways

• Mental accounting, a behavioral economics concept introduced by Nobel Prize-winning economist Richard Thaler, refers to the different values people place on money.
• 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.
• To avoid the mental accounting bias, individuals should treat money as completely interchangeable no matter where they allocate it—whether to a budgeting account for everyday living expenses, a discretionary spending account, or a wealth-building account like a savings and investment vehicle.

In his 1999 paper "Mental Accounting Matters," Richard Thaler, currently a professor of economics at the University of Chicago Booth School of Business , defined mental accounting as “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 the 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 it among different accounts. They also should value a dollar the same whether it is earned through work or given to them.

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 overpayment 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.

To avoid mental accounting bias, people should value every dollar they receive in the same way—whether it is earned through work or given to them. Don't think of a tax refund as a windfall, suitable for splurging.

The mental accounting line of thinking seems to make sense but is in fact highly illogical. For instance, some people keep a special “money jar” or similar fund set aside for a vacation or a new home, while at the same time carrying substantial credit card debt . 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 .

Broken down further, it’s illogical (and, in fact, detrimental) to maintain a savings jar that earns little or no interest while simultaneously holding credit card debt that accrues double-digit figures annually. 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.

The solution to this problem seems straightforward yet 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. Many people feel, for example, that money saved for a new house or a child’s college fund is simply “too important” to relinquish, even if doing so would be the most logical and beneficial move. 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 2007-2008 financial crisis.

People also tend to experience mental accounting bias when investing. 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 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 the portfolios from one another.

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. This is the loss-aversion effect that can lead investors astray with their decisions.

Why Do We Do Mental Accounting?

People have a natural tendency to treat money differently, depending on factors such as its origin and intended use. That way of thinking gradually makes less sense the more you think about it and can end up actually being detrimental to our finances.

Is Mental Accounting a Behavioral Bias?

Yes. Behavioral biases can be described as irrational beliefs or behaviors that unconsciously influence our decision-making. And mental accounting can be described as resulting in illogical ways of viewing and managing our money.

How Can Mental Accounting be Prevented?

The key to dealing with mental accounting and not succumbing to it is to treat money as interchangeable and not give it labels. Don’t consider certain money less important because it came from an unexpected source or continue to park money in a savings account paying little to no interest when you have debts to repay with much higher borrowing costs.

Mental accounting is a trap that many including seasoned investors fall into. The majority of people assign subjective value to money, usually based on where it came from and how it’s intended to be used. While that approach may sound harmless and totally reasonable, it can work against us and leave us economically worse off.

Richard H. Thaler. " Mental Accounting and Consumer Choice ." Marketing Science, Vol. 4, No. 3 (Summer, 1985). Pages 199-214.

The University of Chicago Booth School of Business. “ Richard H. Thaler .”

Richard H. Thaler. “ Mental Accounting Matters .” Journal of Behavioral Decision Making, 12. Page 183.

Richard H. Thaler. “ Mental Accounting Matters .” Journal of Behavioral Decision Making, 12. Pages 183-206.  

IMDB. " Full Cast & Crew: The Big Short (2015) ."

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