A lot of economic and financial research deals with behavioral biases, those occasions where the mind plays tricks with us and leads even very intelligent people down the path of irrational and sub-optimal decisions. Other bloggers have pointed out some of these biases before, see Plan Invest Escape on cognitive biases. Also, Northern Expenditure wrote an interesting post on the temptation of instant gratification over saving for the future. Among all the different biases, Mental Accounting is not that well-known but it’s one of the most fascinating. Mental accounting, sometimes called Framing, shows up in human behavior in the following ways:

Intentionally or unintentionally creating different buckets of money and ignoring the fact that money is fungible; displaying different degrees of risk aversion and/or different propensities to consume out of different buckets.

Quite intriguingly, in personal finance the mental accounting bias is not only committed frequently, sometimes it’s even celebrated as a great innovation. It’s not a defect, it’s a feature! Some of the well-known financial gurus fall for this fallacy and are not even ashamed! Continue reading “Beat Behavioral Bias: Mental Accounting” →