"Thence came forth Maul, a Giant. This Maul did use to spoil young Pilgrims with Sophistry."
An understanding of the term mental accounting can help with spending, budgeting, and investing decisions.
Mental accounting is a type of framing where people mentally divide their assets and income into buckets. Depending on the particular mental account, vastly different decisions are made regarding the money, even though money should be exchangeable. The behavioral economists who study these things mainly seem to be interested in trying to predict and explain behavior, so they don't necessarily label mental accounting as a negative thing. There can indeed be some positive aspects to mental accounting. However, when a particular mental accounting decision has a clear negative impact on current or future net worth and there appears to be no rational motive for it, it is sometimes referred to as a mental accounting error.
The classic example of a mental accounting error is when a person maintains a large credit card balance at 18% while also maintaining an even larger checking account balance earning 1% that could be used to eliminate the debt. For some individuals, even if they are aware of the money that could be saved, they may choose not to do so because the checking account is viewed as "savings" or an "emergency fund" that cannot be tapped. For other individuals, the high checking account balance in isolation may make them feel wealthy, and a reduction of the account would make them feel less so. I will confess to such an attitude when I was in my early 20's, and thus I continued to make this error for a year or two.
Now you may be thinking you would never do something so stupid. Lest you get too smug, I would point out that many other mental accounting errors are extremely subtle and even the people who are experts in this field admit to making such errors.
Here are some more recent mental accounting errors I have made and corrected:
- Treating each account separately. I used to diversify each of my accounts individually instead of across all accounts. I did this because I didn't want any particular account to have a high volatility and because an individual account statement would otherwise look too concentrated in a couple of positions. This is definitely mental accounting, separating my money based on account. However, if the accounts are similar in nature (e.g. three different IRA accounts), then this is usually detrimental to net worth for no reason. It results in higher fees since the position sizes are all smaller. I had to train myself to avoid looking at each individual account in isolation, and instead look at my total portfolio across all accounts. This saved me money.
- Treating fees separately from all other money. A lot of people have a real attitude about fees. Anything labeled as a fee is treated as an evil to be avoided literally at all cost. My emotional side gets worked up about fees as well, but I have often found it's cheaper to pay them than the alternatives we choose. For example, suppose you find yourself in need of cash and the only nearby ATM is not your bank, so you will have to pay a $2 ATM fee. If you then drive 5 miles to your bank to save the $2 fee, you probably will spend more than $1 in gas on the 10 mile round-trip. If you have a newer vehicle, you also probably incurred way more than $2 in depreciation and wear and tear on the vehicle. (The IRS would consider your 10-mile trip to cost you $4.85, and the estimates from AAA are in the same ballpark.) I used to spend $5 elsewhere to save $2 on ATM fees because I hated the fees. The fact that "$2.00 Terminal Fee" is immediately printed on the ATM receipt highlights the fee, while the fact that the gas and maintenance outflows come later obscures the alternative costs. ATM fees were just the tip of the iceberg; I learned to be careful about all sorts of fees and their alternative costs.
- Treating the same amount of money differently depending upon context. We often tend to view a particular amount of money based upon the surrounding context. For example, if a coffee maker that we are interesting in purchasing is always seen selling for $39, and we suddenly find it selling at a particular store for $19, we spend time and effort to obtain it at that price. After all, it's 50% off! On the other hand, if a dining room set normally sells for $1999, and we see it for $1979, we are unimpressed because the percentage different is small. Yet $20 is still $20 regardless of context. The biggest lesson here for me was not to disregard comparatively small savings when making large purchases.
For further reading about mental accounting, I would recommend Richard Thaler's Mental Accounting Matters (Warning: 2.4 MB pdf file). It's not an easy read, but it's very interesting and informative.