Mental Accounting

Definition

Mental accounting is the tendency of individuals to categorize money into separate “mental accounts” based on subjective criteria, rather than treating all money as fungible. This leads to irrational decisions like:

• Treating gambling or crypto winnings differently than salary
• Splurging bonuses but being frugal with savings
• Over-segmenting investments by emotion

Case Study

A man in Jaipur received a yearly bonus of 1,20,000 rupees from his company. Instead of treating it like part of his overall income, he mentally labelled it as “free money” meant only for enjoyment. Even though he had an outstanding credit card bill and an unfinished emergency fund, he decided to use the entire bonus to buy a new phone and take a short trip. At the same time, he continued being extremely cautious with his regular monthly salary, avoiding even small discretionary expenses. By separating the same pool of money into different mental buckets, he ended up making choices that were not aligned with his actual financial priorities.

Historical Reference

Coined by Richard Thaler in the 1980s, mental accounting challenges rational theories of utility maximization. It explains how framing money differently based on origin or intent can skew spending, investing, and saving behavior.