Mental Accounting

Behavioural economists might think it's irrational but it is actually a feature

If you were to ask a behavioural economist, particularly Richard Thaler, “mental accounting” is irrational. This is the name given to the behavioural quirk where people categorise accounts in their heads.

Let us defer to the oracle of the times, namely ChatGPT, on this:

Mental accounting is a cognitive bias where people mentally categorize and treat money differently based on arbitrary factors, such as the source of income, intended use, or budgetary “buckets.” This often leads to irrational financial behaviors.

Key aspects:

• Segregation of Money: Treating identical sums of money differently depending on labels, e.g., a tax refund as “fun money” vs. salary as “necessity money.”

• Budget Categories: Assigning rigid budgets for specific purposes, like groceries or entertainment, and sticking to them even if reallocating funds could be more optimal.

• Windfall Gains: Spending unexpected income more freely than regular income due to its perceived “bonus” nature.

• Sunk Cost Fallacy: Continuing an expense because of prior investments, even when it’s no longer rational.

It impacts saving, spending, and investing decisions, often leading to suboptimal outcomes.

According to most literature, mental accounting is a bug - because money is fungible, looking at money across different budget categories doesn’t make sense. You need to evaluate all the categories according to the same stick if you are perfectly rational. And all that.

However, as has been well documented in recent times, the “heuristics” as described by most behavioural economists are not really irrational at all, and interpreted as irrational by economists because they work under the assumption that all economic actors are “perfectly rational”. . And mental accounting is no different.

Today is my 14th wedding anniversary, and so as my wife and I were making plans for today earlier this week, I decided that I’ll take the day off from work.

I woke up early as usual, went to the gym in the morning as usual and then dropped the kids to school as usual. And then I came home and did not work.

As we had planned, my wife and I walked up to Vidyarthi Bhavan (a good 2km away) for breakfast, and then took a much longer walk around Basavanagudi and Shankarapuram, drank coffee along the way, and then walked back home.It had been a long time since we had spent 2-3 hours in succession just talking to each other about random things without other disturbances, devices or domestic responsibilities.

If you want to know why this particular walk, watch this:

Or read this:

I convinced her to meet me the following day. And we agreed to meet in Basavanagudi (basically I was playing on “home ground”).

We spent some three hours together that day, and for virtual strangers who had only bantered on Orkut and LiveJournal and GTalk earlier, the breadth and depth and ease of conversation was rather spectacular. I remember this rather “special” feeling as I walked back home that day.

Back to today, we got back home around noon when my wife shut herself in a room saying she will “just chill for the next couple of hours”. Now, I had the next two hours for myself. One thought was that I could now go get some work done (as many of you might know, when you are running an early stage startup, work never ends). However, I stopped myself saying that I’ve explicitly taken the day off and I need to respect that.

I, too, went off to chill, and that’s what I’ve been doing since. Work will get done tomorrow, when I’m “back to work”.

One way to think of this is that I wasted a perfect half day (which was surplus to requirements to our anniversary “celebrations”) only because I’d taken the rest of the day off. This is how a behavioural economist, who thinks mental accounting is “irrational”, would think.

However, that I’m doing mental accounting (today: holiday; tomorrow: work) means that it gives me a LOT of peace of mind and prevents much decision fatigue. If not for mental accounting, I would’ve been asking myself every few minutes today if I should chill or work (apart from the time spent with my wife, that is). That would have been a significant waste of mental resources. By compartmentalising, I’m making things much easier for myself.

And it is the same in all contexts where people perform mental accounting - once you account for the transaction costs of making decisions and calculating precise cost-benefit payoffs, mental accounting is actually rational. Because you have done a one time exercise in budgeting and compartmentalising and allocating, all subsequent decisions are individually made far easier. Each decision in itself may not be the most optimal, but the system on the whole is optimal.

I guess another way of putting it is using engineering, rather than economics - when every part of the system is locally optimised, the system on the whole is suboptimal.