Mental Accounting

What is Mental Accounting?

Mental accounting refers to the cognitive process by which people categorize, evaluate, and keep track of their financial activities. Instead of treating all money as the same, individuals often create mental "budgets" or accounts (for example, money for vacation, rent, or savings) and make decisions based on these mental categories, even when it leads to irrational outcomes.

Key Concepts of Mental Accounting

Categorizing Finances
- 💵 People assign money into different mental “accounts” (e.g., savings, spending, entertainment), treating them differently even if the money is fungible.
- Example: Someone might refuse to dip into their “vacation fund” to pay for a necessary car repair, even though it would make sense to prioritize the urgent expense.

Sunk Cost Fallacy
- 💸 The tendency to continue an endeavor once an investment in money, effort, or time has been made, even when it would be rational to cut losses.
- Example: Attending a concert you no longer want to go to just because you already bought the ticket.

Windfall Gains
- 🍀 People treat unexpected gains (like a bonus or lottery win) differently, often spending them more frivolously.
- Example: Someone may use a tax refund to buy luxury items rather than save it for long-term goals.

How Does Mental Accounting Work?

Step 1: Earn money.
- 💼 For Regular Income: Categorized into accounts like rent, bills, savings.
- 🍀 For Windfall Gains: Treated as free money, often spent more casually.

Step 2: Face a decision.
- 💸 For Sunk Costs: Decisions are influenced by the amount already invested, leading to irrational choices.

Step 3: Follow the mental budget instead of overall financial logic.
- 🧮 You stick to your mental categories, even when shifting money might be smarter.

Categorizing Finances
- 💵 Dividing money into mental "accounts" (e.g., rent, vacation).

Sunk Cost Fallacy
- 💸 Continuing an endeavor because of past investments.

Windfall Gains
- 🍀 Spending unexpected gains more frivolously.