Mental Accounting: This Is How You Budget Your Life

Mental accounting is a model of consumer behavior that describes how people evaluate economic outcomes in their minds. That is, how they calculate their financial resources in the form of mental accounts, and how this impacts their purchasing process. We make mental accounts to manage and keep track of our spending. Consciously or unconsciously, we situate money into accounts for savings (e.g. to buy a new car or home) and expenses (e.g. for gas, clothing, food, and utilities). Individual accounts don’t function just on the presence of our current wealth, but in the context of two accounts: the current budget period (e.g. monthly due to bills, yearly due to annual income) and the expense itself.

This theory aligns directly with other models of behavioral economics. Framing is one of the strongest effects that play a part in this: it is how a person subjectively perceives (”frames”) a transaction in their mind based on the utility they expect. Think of it as how much value you think you will get from a purchase. Thus you account that as the “worth” of the product or service. It is this psychological process that incentivizes us to minimize loss than to maximize gain. It’s also why we feel pain when paying from something. Recall that unpleasant feeling you experience when you see the number at the gas pump rise as you fill your tank.

Though mental accounting mostly boils down to how gains and losses are segregated. Mental accounting works on the basis of separate “buckets”. These could be “savings”, “salary”, “bonus”, and “entertainment”, for instance. This is why it’s easier to splurge from a “bonus” account. You see it as “free money”. Whereas spending from your “salary” account leaves you more frugal. The fact that both are equally valuable does not matter. We adhere to self-imposed budgets and account boundaries like our life depends on it. If you have a mental account of “vacation fund” or “leisure budget”, you aren’t likely to use that money to cover a necessary car repair.

This is because transactions operate on two values. Acquisition value is the money you part with for acquiring a good or service. Transaction value is what you experience when you get a good deal. If what you pay for leaves you about as satisfied as you mentally rehearsed and expected it to, the transaction value is zero. But if the price you paid is lower than the gain you experienced, the transaction value is positive, thus the total utility is higher. Hence it is much more painful to spend from the “salary” account as opposed to the “bonus” account. The “salary” account is linked to work, and thus much be traded for something of a high value. Whereas “bonus” isn’t necessarily linked to effort and doesn’t carry such high expectations in our minds.

Real-life implications of mental accounting:

• Consumerism: you receive a tax refund and see it as “extra money” that you can afford to spend on a luxury item, while you regular budget remains just as tight. The “extra” label results in more impulsive spending.

• Finance: an investor treats investment gains differently from the original capital. They may risk the “profit” on high-risk ventures while being super conservative with their principal. This results in overinvestment of gains and substandard risk management.

• Business Budgets: a company divides its budget into separate accounts for marketing, research and development, and operations. Leftover funds are often spent in one department even if reallocating them could yield better results. Rigid budgets thus often lead to missed opportunities for cross-functional investments that would benefit the entire organization.

How you might use mental accounting as a thinking tool: (1) be aware of your categories — recognize your mental accounts (e.g., “essentials”, “leisure”, “bonuses”) and reflect on how these categories affect your spending; (2) evaluate opportunity cost — assess whether sticking to rigid budgets is causing you to miss out on better opportunities and consider reallocating money between mental accounts to serve your financial well-being; (3) challenge the label — ask yourself if the way you label money is influencing your decisions irrationally, and practice thinking of every dollar as the same as any other, regardless of the source; (4) integrate budgeting — try to create a holistic budget that considers your total resources instead of segmented accounts; (5) see it and sort it — practically review your spending patterns to spot mental accounting and whether it is leading you to inefficient or irrational choices.