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Mental Accounting

An economic concept established by economist Richard Thaler.

Tina S
Tina S
Jan 17, 2010
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A concept first named by Richard Thaler (1980), mental accounting attempts to describe the process whereby people code, categorize and evaluate economic outcomes. 

Definition:
 
An economic concept, which contends that individuals divide their current and future assets into separate, non-transferable portions. The theory purports individuals assign different levels of utility to each asset group, which affects their consumption decisions and other behaviors.

Investopedia.com: Mental Accounting 
 
“An economic concept established by economist Richard Thaler, which contends that individuals divide their current and future assets into separate, non-transferable portions. The theory purports individuals assign different levels of utility to each asset group, which affects their consumption decisions and other behaviors."

Belsky and Gilovich (1999) 
 
“If Richard Thaler's concept of mental accounting is one of two pillars upon which the whole of behavioral economics rests, then prospect theory is the other."


Mental accounting, utility, value and transaction:
 
In mental accounting theory, framing means that the way a person subjectively frames a transaction in their mind will determine the utility they receive or expect. This concept is similarly used in prospect theory, and many mental accounting theorists adopt that theory as the value function in their analysis.
 
Another very important concept used to understand mental accounting is that of modified utility function. There are 2 values attached to any transaction - acquisition value and transaction value. 
 
Acquisition value is the money that one is ready to part with for physically acquiring some good. 
Transaction value is the value one attaches to having a good deal.
 
If the price that one is paying is equal to the mental reference price for the good, the transaction value is zero. If the price is lower than the reference price, the transaction utility is positive.
 
Learn Mental Accounting:
 
Behavioral economists say that mental accounting works like this: let’s say you have bought a $150 ticket to a concert. When you show up at the door and realize you have lost your ticket, do you buy another? Probably not.
But let’s say you hadn’t bought the ticket yet, and you show up at the door of the concert hall to buy your ticket. Unfortunately, you realized you’ve lost $150 in cash since you walked from your car. LUCKILY, you still have enough in your wallet though to cover the cost of the ticket. Do you buy the ticket? Yes.

Why?

Both scenarios are a loss of $150. However, in the second scenario you separate the losing of the $150 from the purchasing of the ticket. In the first you consider the cost of the event as a total of $300 and retch at the high cost.
It turns out that Mental Accounting is a huge contributor to the low rates of savings in the US (in 1999 it was 4% in the US and over 15% in Japan).
 
For investors:

Investors derive some benefits from this behavior. Earmarking money for retirement may prevent us from spending it frivolously. 
 
Mental accounting becomes a problem, though, when we arbitrarily divide the components of total return: income and capital appreciation. Many investors feel that they can't spend capital appreciation--that's principal--but they can spend income.

Ironically, investors can erode their principal in a quest for generous income streams. Take a bond fund that pays a high dividend, but generates a negative capital return. Your original investment would shrink, not grow, every year. Eventually, your dividends would shrink as well.

That's because a bond fund's yield is nothing more than a percentage of its asset base. So even if a fund maintained, say, an 8% yield, the amount of its dividends would fall if its capital returns were negative, eating away its asset base.

When Do You Use Mental Accounting?
 
How can you know if you are more likely to be affected by mental accounting? Here are some clues:
 
  • You don’t think you spend, but you have trouble saving
  • You have savings in the bank, but your credit cards aren’t always paid off
  • You spend more with credit cards than with cash
  • You’re more likely to spend your tax refund than your savings on a new itouch.

Things You Should Know about Mental Accounting:
 
  • We have a tendency to value money differently depending on where it comes from. If you win $50 in the lottery – considered “found” money – you more likely to spend that on garbage than the $50 you earned on the job. If you get  tax refund – you’ll run out and spend it instead of saving.
  • We are victims of the concept of “relative cost”. You want to spend $10,500 dollars but the used car dealer says  it’ll be $500 extra this time of year. Mental accounting tells you that $500 in compared to the cost of the car isn’t that bad. But you want to buy a washing machine for $500 – you show up and they say it’s now $1000. Do you buy it? No. Mental accounting tells me that’s crazy talk.
  • Plastic equals fake money:It sounds like the oldest most overused money trick but it still holds true – people do spend more with credit cards. When the weight of your wallet doesn’t change, you are less likely to think you’ve really spent anything.
 
How can you fix the problem of Mental Accounting?
 
  • Do what the book says: “Imagine that all income is earned income.” You worked for granny’s xmas check, so don’t waste it.
  • Pretend you don’t have the plastic. Although Belsky and Gilovich haven’t gone all Dave Ramsey on us and told us not to use credit cards, they are saying we should stop and think: would I buy this if I was using cash?
  • Use mental accounting to your advantage by automatically funneling money out of your paycheck (Ramit does this, and has told you to follow suit)
  • Remember that money is money. $3,000 more on a $200,000 house isn’t less money than $3,000 more on a $3,000 dining room set.
  • Record keeping is the key to success – I’ve always claimed this, and this book enforced this more than anything. (Yes, we’ve regressed back to Ramit’s dreaded David Bach latte factor.) Little things can add up. $10 a day in extra soda, gum, magazines and lunch out is $3,500 bucks a year.

 
Keywords: Mental Accounting,Richard Thaler ,1980,Belsky,Gilovich,transaction,theory,use,money,relative cost,problems,record keeping,automatic funneling,earning money,pretend,value,tax, refund,saving.



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