What’s your mental accounting with money?

The invisible rules we make with money

I am from Visakhapatnam (or as we fondly call it, Vizag), a coastal city in Andhra Pradesh. It’s usually a quiet place, not packed with too many people or fancy weekend hangouts.

But I have a favourite spot: a rooftop restaurant overlooking the sea. Dinner here on a cozy evening, the sound of waves from the beach, a moonlit sky, and the nice breeze — it’s something I really enjoy.

Been to Vizag? Know this place?

Here, a small brownie with a scoop of ice cream easily costs ₹500–₹600. Yeah, this is one of those premium places that mostly charges for the ambience.

So I told myself: “I’ll go there just once a month.”

See, I’m not someone who budgets in a very detailed way. I don’t sit and assign exact amounts to travel, entertainment, or groceries every month. I just roughly know how much I spend overall.

Even during those lighter months, when I haven’t spent much and can technically afford to go to that restaurant again, my guilt stops me.

I struggled to reason it out to myself. Until I came across the term: mental accounting.

What’s mental accounting?

Companies follow regular accounting that has set rules. Incomes, expenses like employee costs, entertainment, and even department-wise budgets are all clearly defined.

But mental accounting is something we individuals do in our heads. There are no fixed rules. The only way to understand our mental accounting is to watch how we behave and try to figure out the patterns.

In my case, I mentally accounted for that restaurant expense as ‘discretionary’ spending.

Somewhere along the way, I had created a mental rule (or maybe a boundary) that going to this restaurant more than once a month means I’m overindulging or spending beyond my means.

Now here’s the twist: the same me doesn’t feel that same guilt during months when I receive a bonus or performance-based extra money. I’ll happily indulge.

Why do you think? It’s the same hard-earned money, just another part of my salary. So why am I treating it differently?

Let’s take another scenario.

Now that you know how I feel about spending on that restaurant 😄, do you think I’d ever be tempted to sell a few units of my retirement fund (because markets are good and returns are above normal) just to go there?

I guess you already know the answer.

At the end of the day, it’s all my money. But how I received that money, and how I’ve mentally set it aside, plays a big role in how I choose to spend it.

As Richard Thaler, the father of mental accounting, who has spent decades exploring behavioral economics, puts it:

“Money in one mental account is not a perfect substitute for money in another account”

I’m sure you have your own mental accounting rules, too.

Some food for thought -

1. Say you want to buy a shirt worth ₹800. You hear from someone that the same shirt is being sold for ₹500 (at ₹300 discount) at a store just 20 minutes away. Would you go? Most likely, yes.

Now, imagine you’re buying a TV worth ₹30,000, and another store, also 20 minutes away, is offering a ₹300 discount. Would you make the trip in this case?

2. Let’s say your friend went on a vacation to Goa and played at a casino. He started with ₹1,000 and returned to the hotel with ₹25,000 in winnings.

But he couldn’t sleep and decided to try his luck again. This time, he lost everything and returned to the room with nothing.

Your friend says that his actual loss was ₹1,000, with which he started. But you tell: what was your friend’s actual loss? Was it ₹1,000, or ₹25,000?

You might have your own answers depending on your mental accounting rules and reasoning.

But economists answer these questions in the following way:

‘In the first case, ₹300 is still ₹300. So if you’re okay driving to save it on a small item, why not on a bigger one?.’

‘In the second case, your friend lost ₹25,000, not just the ₹1,000, because he had that money before losing it.’

This is how economists argue, because they look at things through a rational lens. But we know that money decisions are not always rational.

What’s the point of these mental accounting rules?

The point is that, whether we like it or not, we all have our own set of mental accounting rules, and we need to acknowledge them to improve our financial behaviour.

Sometimes, they help. Like me, many of us don’t like spending or taking out money from something that’s marked in our heads as ‘for retirement’ or ‘children’s education’ and so on.

But sometimes, our rules may seem silly. We may spend 30 minutes comparing every grocery app for the cheapest deal, but we do not spend the same time switching to a better savings account with higher interest.

After spending 20 years researching mental accounting, Thaler, in his highly-regarded paper, doesn’t conclude whether it is good or bad. He says there’s no fix for it but that it “matters.”

Like anything in life, we must hold on to the good and improve where we fall short - and that starts with being aware of our mental habits.

I don’t know how to say that without sounding preachy, but I hope you get what I meant :)

---

This Newsletter was written by Satya Sontanam.

Do read "Free Coriander, Cheap Sugar, and the Price of Loyalty" newsletter on our Side Notes by Zerodha Varsity.

For any feedback or topic suggestions, write to us at varsity@zerodha.com.