Mental accounting, the process of compartmentalizing expenses, can affect consumer decision-making regarding spending and investing. Consumers often engage in mental accounting based on subjective reasons, such as the intent of the money. Increased awareness of the impact of mental accounting can help consumers make more rational financial decisions.
Modern economic theory is largely based on consumer decisions being sensible and objective. However, studies have shown that mental accounting colors the decision-making process regarding spending and investment options. Mental accounting is the process of compartmentalizing various investments or expenses, viewing the different compartments as separate and unrelated to each other. For example, if an individual buys a $4 US dollar latte and accidentally spills it, he will be very resistant to buying another one, but will have no problem buying $4 worth of gasoline. Although the dollar amounts of the purchases are identical, buying more coffee for $4 USD seems wasteful to the consumer, but buying $4 USD worth of gasoline is acceptable to him.
Consumers engage in mental accounting based on purely subjective reasons, such as the intent of each account or the source of the money. For example, when consumers receive money for a birthday present, what they do with the money may depend on what the giver stated was the intent of the money. If the donor stated that the money was for a college fund, the consumer will likely keep it. On the other hand, if the giver expressed that the recipient should go out and spend it on something fun, the recipient will do so, even if he owes back money on his rent. Some people save the money they earn, ascribing greater value to it, but easily spend the money they receive from others, considering it as an extra gift.
Mental accounting can significantly affect investing and banking. For example, investors may spend a lot of time and effort maintaining two portfolios, one for “safe” investments and one for riskier investments. In reality, the risk is the same whether the accounts are separate or together. Keeping the two types of investments in a single portfolio allows the investor to more effectively balance the objectives of mitigating risk and enhancing returns. In the same way, consumers can keep a college fund firmly in an underperforming savings account, while racking up an exorbitantly high-interest credit card bill.
Economists agree that money is interchangeable, regardless of its origin or purpose. Money received as a gift or from a tax refund is no different than money earned. Getting rid of outstanding debt can improve your financial outlook more than maintaining a low-interest savings account. Increased awareness of the impact of mental accounting through the study of behavioral finance may help consumers avoid careless spending of “found” money and irrational purchasing and investment decisions.
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