What is mental accounting and why are we so bad at ‘organizing’ our finances

The truth is—personal finance is often a messy afterthought. And if you’re like many of us, you most likely have some sort of crude saving system that spans two or more accounts. For example, some keep a “main account” to withdraw money for everyday expenses and purchase necessities like groceries, food, and used clothing. This main account is often supplemented with a secondary account that functions like a stash for larger purchases—mostly for big trips or in case a laptop breaks.

In plain terms, mental accounting is the completely-subjective cognitive organizing of your money into different “accounts.” It’s how your brain—consciously or unconsciously—treats your finances differently depending on the source or its intended use.

You might have a going-out or entertainment account, a necessities or rent account, or an expensive side-hobby account. If you have ever rationalized spending more on, say, a set menu at a Michelin star restaurant than buying food at the grocery store, you’ve practiced mental accounting.

“Real people have trouble balancing their checkbooks, much less calculating how much they need to save for retirement—they sometimes binge on food, drink, or high-definition televisions. They are more like Homer Simpson than Mr. Spock.”

The term mental accounting was first introduced in a landmark study by behavioral economist Richard Thaler in 1999. He set out to better understand the psychology behind consumer choice. In his famous experiment, he surveyed a group of respondents about a trip to the movie theater—it went a little like this:

Imagine that you’ve decided to see a movie and have paid the admission price of €10 per ticket. As you enter the theater, you discover that you’ve lost the ticket. The seat was not marked, and the ticket can’t be recovered. Would you pay €10 for another ticket? Only about 46% of respondents said they would—when Thaler rephrased the question, the result was completely different.

Imagine that you have decided to see a movie where admission is €10 per ticket. As you enter the theater, you discover that you have lost a €10 bill. Would you still pay €10 for a ticket to the movie? A whopping 88% said they would purchase another ticket. But, why?

Objectively, these two situations are exactly the same—you’ve lost €10 without seeing the movie. But that’s not how we organize costs.

As Thaler was quick to theorize—we compartmentalize our spending into different budgets, each covering a need or want.

In the first case, you’ve already spent your movie budget so spending €20 to see a movie is out of the question. But in the second case, the €10 gets written off as a general expense. You didn’t spend that money on a movie—you just lost it. That might seem pretty illogical, but that’s the point.

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The logical choice in both cases would have been to tuck your tail in, head home, and watch some TV, realizing that you had already lost money that would have been used for entrance to the film. This assumes that we have a bulletproof handle over our current and potential wealth or worth. Behavioral economists were quick to recognize that we actually don’t—we often make topical (individual) financial decisions.

Take a study by Kahneman and Tversky, that Thaler cited in his 1999 paper, for example. They asked people whether they would drive 20 minutes across town to save €5 on a €15 calculator or €5 on a €125 jacket. Remarkably, much more people said they would drive for the calculator than the jacket.

This happens because of something called “framing.” In essence: we look at purchases individually, rather than over all time. So, by comparison the €5 saved on a €125 purchase is pocket money. And it illustrates that we don’t base our decisions on absolute value.

It’s the same phenomenon that makes you splurge on a vacation or on business trips in expensive cities. What difference does a few extra euros or dollars make if you have already saved up for months?

Not a whole lot, it turns out. Most real world examples aren’t exactly like the movie ticket example. Instead, we tend to frame each transaction in matters of what we’d gain for the money paid. Which is why the calculator seems like the sweeter deal. If you’ve ever thirstily stood in front of a soda machine on a hot summer day, clenching a dollar bill or euro coin in your hand, you know this.

I’m thirsty. I buy a soda. I’m no longer thirsty. Hydration gained.

Another of Thaler’s studies perfectly illustrates this. He asked people whether they’d pay more for a beer from a nearby resort or from a convenience store. Not surprisingly, people were willing to pay more for a beer from the resort than the store. Same result. Different contexts.

While it would be easy to draw quick conclusions about how we should behave—and there have been many at a policy level with questionable results—we should remember that everyone is different. 

Understanding the psychology behind mental accounting is, however, still useful from an awareness perspective. Just as in the resort situation, you can always take a step back and look at the context. Am I buying something because I actually want it? Or am I performing budgeting acrobatics by somehow attaching a higher value to this purchase?

It’s also comforting to know that even some of the most seemingly rational people are also susceptible to making mistakes with mental accounting. The simple way to get past this is to be a bit practical.

We all splurge or make spur-of-the-moment purchases. One effective way to spend less is simply giving yourself access to less, or by putting aside money for your personal projects and dream purchases. That way, you can splurge guilt-free when the time comes.

After all, life’s best lived with both a healthy dose of realism—supplemented with some wide, wide wiggle room.

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