What is mental accounting?
In accounting terms, Tk 1,000 is the same Tk 1,000 wherever it sits. But in our heads we split money into separate accounts: “salary money”, “Eid bonus”, “money sent from abroad”, “share profits”, “grocery money”. And we spend or risk the money in each account differently. This is called mental accounting.
The idea was popularised by the American economist Richard Thaler, who received the Nobel prize in economics in 2017 for this work. In the Nobel committee’s words, people simplify money decisions by keeping separate mental accounts, judging each decision on its own rather than looking at the overall effect.
Say Karim is careful with money every month and even haggles over a Tk 20 rickshaw fare. But as soon as his Tk 20,000 Eid bonus arrives, he spends almost all of it in one afternoon, because it feels like “extra money”. Yet Tk 20,000 of salary and Tk 20,000 of bonus buy exactly the same things. The story is made up.
Why it matters to an investor
- Playing with “house money”: many treat share profits as “the market’s money” and take far bigger risks with it, as if losing it would not matter.
- Saving while in debt: keeping money on deposit at a low rate while carrying a loan or credit card debt at a higher rate.
- Seeing the portfolio in pieces: looking at each investment in its own account hides the risk and return of the whole portfolio.
- There is a good side too: keeping the emergency fund or a child’s education money in its own account makes it less likely to be spent on a whim.
A famous experiment: the lost ticket
The psychologists Amos Tversky and Daniel Kahneman (1981) gave two groups of people two situations. The first group was told: you are going to a play with a $10 ticket price, and on arriving you find you have lost a $10 note. Would you still buy a ticket? About 88% said yes.
The second group was told: you bought a $10 ticket in advance, and on arriving you find you have lost the ticket itself. Would you buy another? Only about 46% said yes. In both cases the loss is the same $10. The difference is only in the mind: in the second case people feel the “theatre account” has now cost $20.
Where it shows up in Bangladeshi life
- Remittances: when money earned the hard way abroad arrives, families sometimes treat it as “money for something big” and put it into land or a house, and sometimes as “extra” and spend it quickly. Either way, the question should be what is needed when all income and spending are taken together.
- Sanchayapatra or FDR profit: thinking the principal is “untouchable” but the profit is “spending money” can let inflation shrink your real savings.
- Lottery, prize bond or gift money: “windfall money” is often spent with the least thought.
- In shares, “I’ve got my original money back, the rest is free”: the rest is your money too, and if it is lost, you are the one who loses it.
Not always bad
Mental accounting is not entirely wrong. The envelope method of budgeting, a separate emergency fund, or savings kept apart for each goal are all deliberate ways of separating accounts to keep self-control. The trouble starts when the label on an account makes us forget that all the money comes from one pocket, and that decisions should be made looking at the whole picture.
Worked example
- Say you have Tk 1,00,000 in a one-year FDR at 9% a year. Interest: Tk 9,000; less after tax at source, say Tk 8,100.
- At the same time you have a Tk 1,00,000 personal loan at 14% a year. In simple terms, that is about Tk 14,000 of interest a year.
- In your head there are two separate ledgers: “savings growing” and “loan being repaid”. But the money comes from and goes to the same pocket.
Result: taken together, the two ledgers cost about Tk 5,900 a year, net. This is not a recommendation; there are reasons to keep emergency money at hand. But the sound way to decide is to look at both ledgers together. The numbers are only an example.
Common mistakes
- Treating profits as “free money” and taking risks with them you don’t understand.
- Spending bonus, remittance or gift money with less thought than salary money.
- Holding low-interest savings and high-interest debt at the same time without ever comparing the two.
- Looking at each investment separately and forgetting the risk of the whole portfolio.
Money doesn’t carry a label: bonus, remittance and profit are all part of the same wealth, so decide by looking at the whole picture.