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What is it about?

Mental accounting, a term coined by economist Richard Thaler from the University of Chicago, refers to when we code and categorize a purchase, or a the source of income, to justify some of our financial decisions.

If we asked you if you value all of your money equally, you’d probably say yes. A dollar is a dollar. A pound is a pound. A rupee is a rupee. This is called the fungibility of money, and in theory all money is interchangeable and what matters is the bottom line. But we have the tendency to make money decisions based on wholly arbitrary categories that we set for ourselves.

Give me an example!

Let’s say you’re staying in a hotel room and paying $100 for it. There’s a $5 bottle of soda in the minibar. You wouldn’t normally pay that much for soda in a supermarket, but your don’t have to pay right away. You’ll pay when you pay for your hotel bill, so the $5 gets assigned to the “hotel stay account” rather than to the “grocery account”. That is mental accounting in action.

A more prevalent takeover of mental accounting is when we’re budgeting. We’re not saying budgets are bad (on the contrary), but you should pay attention to the decisions you make because of mental accounting. Let’s assume it’s the end of the month. You have zero money left in your clothes category in your budget, but you really need a new pair of pants that cost $30. Because the money allocated for clothes is gone, you don’t allow yourself to buy them. But you still have money left in your lunch category. So instead of using it to buy the pair of pants that you really need, you instead buy three $10-sandwiches.

Because of mental accounting, it’s hard to switch the money allocated from one category to another, no matter how much more sense that makes.

Another aspect of mental accounting is when we treat money differently depending on its source. That explains why unexpected windfalls, such as inheritance money, tax returns, or bonuses, are squandered faster than the money we get from a paycheck. It simply comes from a different mental account.

Key takeaway

Because of mental accounting, we have the tendency to treat our money differently.