There is one financial psychological bias that often appears, and we do it in managing our personal finances, which is called as mental accounting. Mental accounting basically about the way we divide our money allocation from our income and treat them differently based on their respective roles.
This is a practical example. Often after receiving a paycheck, someone immediately does some kind of distribution of the allocation of money. For example, some are for paying installments, some are for living expenses, some are for future investment funds, some are for emergency funds (emergency funds), and some are for fun and leisure.
What is Mental Accounting Trap?
Now the process of dividing money into their respective roles is called “mental accounting” or mentally dividing our paychecks or income into various accounts that have different roles. In other words, this is a budgeting process: or allocating our salary, and then compiling a budget allocation according to the money we receive.
The problems that arise in the mental accounting or personal budgeting process are as follows: mentally we then treat the money differently according to their respective roles.
For example, we will tend to treat emergency fund budgets more carefully, because these funds are used for unexpected purposes. On the other hand, we will tend to be more generous, in using the money included in the budget allocation for fun and leisure.
Mental accounting incidents also arise, for example when someone receives a bonus. Some people will usually be more generous in using the money from this bonus, for example to buy various consumer goods. Why does he tend to spend more money on this bonus? Because he considers this bonus money as “free money” or a kind of windfall.
Likewise, if someone, for example, receives a monetary prize, then he will tend to use this money more generously, compared to the money he receives from his hard work base salary. He will consider his paycheck as something that must be carefully guarded because of the results of his tired work so far. While the prize money is like a windfall that he is free to use splurge and consumptively.
All the descriptions above illustrate the mental accounting trap. Mentally, we treat money differently depending on its role or where it comes from. And economically mathematically, this attitude is actually an irrational attitude.
The Irrational Attitude of Monetary Treatment
Why is it not a rational attitude? Let’s take $500 as the sample.
Mathematically economically, the value of $500 is the SAME AMOUNT, and our treatment of this $500 should be the same. However, mental accounting makes us sometimes treat the same amount of money differently.
As described above, we will consider and treat $500 as a reserve/emergency fund in a much more careful way, compared to $500 that we allocate for fun.
Likewise, our treatment of $500 from our basic salary, will be very different from the treatment when we receive $500 as part of a bonus.
That shouldn’t be the case. Because wherever it comes from, or for whatever the allocation, the money we spend will be the same amount. Whether it comes from salary or bonuses, gifts, a sum of $500 is still worth $500. And because of that, our treatment of this $500 should be the same. Don’t be influenced by mental accounting traps.
The Consequence
But in reality this is not the case. In our daily life, we are often trapped in this mental accounting. And the consequences are sometimes unfavorable.
For example: because mentally accounting we consider a bonus of $500 as a kind of “extra sustenance”, then we will tend to be more generous in using it (eg to buy the latest cellphones often); even though rationally the funds might be more profitable if they bought investment products for the future.
Or another example. Someone, for example, has made a budget allocation for lifestyle costs (eating, traveling and various other lifestyles). And because of the influence of mental accounting, this person will tend to spend all these funds quickly “without guilt”.
Even though the funds that he spends are the same value, whether they are used for lifestyle needs, to pay debt installments, to save, or for daily living expenses. However, people’s treatment and feelings towards the same amount of money will be very different depending on the role or function assigned to the money.
All the examples above are called mental accounting traps.
The History of Mental Accounting
The concept of mental accounting itself was first formulated by Professor Richard Thaller, an expert in behavioral economics from the University of Chicago. His research on mental accounting traps became one of the contributions to why he later won the Nobel Prize in Economics in 2017.
When he gave his Nobel Prize speech in Oslo, Norway, and received a prize money, he joked a little and said: “I hope I can use this prize money wisely, don’t think of this money as “free money” and make me trapped in mental accounting.”
From all the descriptions above, it can be said that mental accounting is the calculation of the role of the division of money in our mental thoughts. The result of this thought then makes our treatment of money different.
The meaning of $500 can be completely different in our minds, depending on where the money comes from, and what we will use the money for.
In fact, mental accounting is not always negative and traps our financial behavior unfavorably. If we are smart, then in fact we can actually take advantage of the mental power of accounting for positive benefits for our personal financial management.
This means that instead of trying to eliminate mental accounting bias from the contents of our minds, we actually try to use it for positive gains for ourselves.
