# Mental Accounting Explained: Definition, Biases, and Real-Life Examples

![Two business people calculate their business in the office.](https://www.investopedia.com/thmb/XTDilPKVje_xqdIej_zVfV67IEY=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/two-business-people-calculate-their-business-in-the-office--918789230-d99594a30c184843ab78fd08d71a1873.jpg)

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> **Definition**
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> Mental accounting is a behavioral economics concept that describes how individuals assign different values to the same amount of money based on subjective criteria, leading to irrational decisions.

## What Is Mental Accounting?

Mental accounting explains how people mentally separate their money into different accounts based on purpose or source. Developed as a concept from [behavioral economics](https://www.investopedia.com/terms/b/behavioraleconomics.asp) by Richard H. Thaler, mental accounting can influence how individuals spend and invest, and may even lead to poor financial decisions like treating a tax refund differently from regular income. To avoid this, consumers should treat money as fungible, meaning all dollars have the same value regardless of their origin.

### Key Takeaways

*   Mental accounting is a concept where people assign different values to money based on subjective criteria, often affecting rational decision-making.  
    
*   Treating money as fungible, meaning all money is the same regardless of its origin or purpose, can help prevent mental accounting bias.  
    
*   People often view windfalls, like tax refunds, as extra money and treat them differently, which can be financially counterproductive.  
    
*   Mental accounting can lead to illogical financial decisions, such as maintaining savings with low interest while carrying high-interest debt.  
    
*   Investors may fall into mental accounting traps by segregating assets into safe and risky portfolios, impacting their overall financial strategy.

## Exploring the Psychology Behind Mental Accounting

In his 1999 paper "Mental Accounting Matters," Richard Thaler, currently a professor of economics at the University of Chicago [Booth School of Business](https://www.investopedia.com/terms/b/booth-school.asp), 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](https://www.investopedia.com/terms/f/fungibility.asp) 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](https://www.investopedia.com/terms/t/tax-refund.asp). 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.

> **Important**
>
> 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.

## Real-Life Example: How Mental Accounting Affects Financial Decisions

Mental accounting might seem logical, but it's actually quite 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](https://www.investopedia.com/terms/c/credit-card-debt.asp). People may treat this saved money differently than debt repayment funds, even though it raises interest costs and lowers [net worth](https://www.investopedia.com/terms/n/networth.asp).

It's illogical and harmful to keep money in a low-interest account while paying high [interest](https://www.investopedia.com/terms/i/interest.asp) on credit card debt. 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.

> **Fast Fact**
>
> 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.

## The Impact of Mental Accounting on Investment Strategies

In investing, people often divide their assets into safe and risky [portfolios](https://www.investopedia.com/terms/p/portfolio.asp), believing this shields overall returns from losses in risky investments.

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.

Thaler uses [Kahneman](https://www.investopedia.com/terms/d/daniel-kahneman.asp) and Tversky's [loss aversion](https://www.investopedia.com/terms/l/loss-psychology.asp) theory: An investor has one stock with gains and another with losses but needs to sell one. 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.

## The Bottom Line

Mental accounting is a behavioral bias where people assign different values to money based on its source or intended use. This can lead them to make poor financial decisions, such as carrying high-interest debt while holding low-interest savings. To counter this, it’s important to treat all money as fungible so that every dollar is interchangeable regardless of origin. By evaluating financial habits and treating all funds equally, individuals can make clearer, more rational decisions. Overcoming mental accounting can reduce irrational spending and promote efficient money management.

> **Article Sources**
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> 1.  Richard H. Thaler. "[Mental Accounting and Consumer Choice](https://www.jstor.org/stable/183904?origin=JSTOR-pdf)." Marketing Science, Vol. 4, No. 3 (Summer, 1985). Pages 199-214.
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> 2.  The University of Chicago Booth School of Business. “[Richard H. Thaler](https://faculty.chicagobooth.edu/richard-thaler).”
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> 3.  Richard H. Thaler. “[Mental Accounting Matters](https://people.bath.ac.uk/mnsrf/Teaching%202011/Thaler-99.pdf).” Journal of Behavioral Decision Making, 12. Page 183.
>     
> 4.  Richard H. Thaler. “[Mental Accounting Matters](https://people.bath.ac.uk/mnsrf/Teaching%202011/Thaler-99.pdf).” Journal of Behavioral Decision Making, 12. Pages 183-206.  
>     
> 5.  IMDB. "[Full Cast & Crew: The Big Short (2015)](https://m.imdb.com/title/tt1596363/fullcredits/cast)."