Wednesday, November 1, 2017

Mental Accounting

What is mental accounting? According to Investopedia, mental accounting is “…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.”1 In other words, it is a form of thinking where an individual allocates his/her resources into different, mutually exclusive categories, even though the resource (usually money) is the same thing and from the same source. It is applied commonly to personal budgets (e.g. meal budget, transport budget, etc.) and investments (e.g. The Bedokian Portfolio, trading portfolio, etc.). This concept was first mentioned by economist Richard Thaler, who had just won a Nobel Prize in Economics

Mental accounting is a form of bias, and it is one of the biases discussed in the field of behavioural economics and finance. Due to the segregation nature of how one places his/her resources, it could have a profound effect on investment and/or trading decisions.

The main reason why I brought this topic up is because I have mental accounting bias. If you have noticed from my ebook and some other writings, I espoused segregating cash into cash for The Bedokian Portfolio, emergency funds and savings. Although it is a form of bias (and “bias” is a not-so-good word, I reckoned), there are some advantages in having it.

Advantage #1 – Accounts and Budgets

Since the term “mental accounting” contains the word “accounting”, you will associate this word with accounts and budgets (and accountants). Almost all businesses and companies have some form of account budgeting in place in order to control and monitor the expenditure. A runaway account or budget is a definite no-no as this would mean uncontrolled spending. Translating this to your personal or family context, it is a good form of controlling your expenses.

Advantage #2 – A Clearer Picture

This is what I think separates good and bad mental accounting bias: the ability to see a clearer picture. Those with bad mental accounting tend to see their capital and resources as parts only, while a good one will see the parts and how they all fit together. By seeing it on a whole, we tend to be more flexible and willing in moving the capital across the various parts. Breaking down the mutually exclusive thinking is key.

An Example

A family man on payday segregates his income into expenditure and his kid’s tuition budget diligently, among others. One day his fridge broke down and this meant buying a new one immediately.

A case of bad mental accounting would see the man lamenting that this fridge purchase is going to eat into his expenditure, and start thinking of having instant noodles for the rest of the month. A good case of mental accounting would see the man looking at other budgets, including his kid’s tuition account. Realising that the tuition account had ballooned to an amount that could cover a couple of months’ worth, he would transfer some of the excess to cover the cost of the new fridge.

1 – Investopedia. Mental Accounting. (accessed 1 Nov 2017)

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