A dollar should be a dollar no matter how it arrives in your hands, but human psychology has a funny way of disagreeing. Behavioral economics research shows that we don’t treat all money equally. We value it differently depending on where it came from or how we perceive it.
Two of the biggest culprits behind this irrational behavior are mental accounting and the endowment effect. These biases shape the way we earn, spend, and save money, often without us realizing it. Understanding them and why they happen is a key step in aligning your financial decisions with your real goals.
Mental accounting is the tendency to assign different subjective values and uses for money depending on how it was acquired. For example, “earned” money, such as your paycheck or investment returns, feels different from “won” money, like lottery winnings or inheritances. That distinction shapes how we treat those dollars. Earned income tends to feel “serious,” while won income often feels like it can be spent more freely. As behavioral economist Richard Thaler first described, this bias helps our brains simplify complex decisions, but it can easily steer us off course.
In my upcoming book "The Lobster League", I illustrate a classic example of mental accounting.
In the book, a married couple gambled in Vegas six times per year and won about $10,000 each time. Since it wasn’t “earned” money through work, it was valued and categorized differently, and was used to purchase luxury items and high-roller dinners. The couple calculated that they had spent over $1.2 million of gambling winnings on luxuries over 10 years, yet they had expressed hesitance at the thought of giving their kids $300,000 each for their business ventures.
Because the money wasn’t earned through effort, it was mentally categorized and valued differently. The same thing often happens with inheritances: Recipients feel freer to spend impulsively because they didn’t “work” for it.
This kind of thinking may feel harmless in the moment, but it can quietly sabotage long-term financial health.
Mental accounting can cause us to assign different values to the same amount of money. Photo by Karola G.
The endowment effect describes our tendency to place a higher value on items we own or were given compared to the same items we don’t own, simply because we already own them. We become more reluctant to sell or give away what we already have because of the perceived (and often inflated) value we’ve placed on an item. That emotional attachment clouds judgment, especially in investing.
It’s really common when people buy a stock and the stock goes down, they set a mental target in their mind for the stock to get back what they paid for it. So if they bought it at $50 a share and it drops to $30 a share, they're unwilling to get rid of it until it gets back to $50 a share. Which doesn't make any sense because $50 has nothing to do with the value of the stock. Stocks are valued based on the outlook and the earnings that the company is going to make in the future.
The attachment caused by the endowment effect traps investors in unproductive decisions. Instead of evaluating based on future potential, they focus on their emotional attachment to the stock and recovering past losses.
We are all susceptible to the endowment effect simply because of human design. To know whether or not you’re experiencing it currently, you need to explore the reasoning behind your decisions. The key questions to test whether or not you’re experiencing the endowment effect are:
If the answer is no, you’re probably being influenced by the endowment effect.
The human brain makes an estimated 35,000 decisions a day, according to research on decision fatigue. To handle that mental workload, we rely on mental shortcuts known as heuristics. Heuristics are critical for the brain to handle so many decisions by simplifying complex situations. They also lessen the mental work necessary to make decisions, allowing us to devote more cognitive resources to activities requiring more intentional, conscious thought. However, the importance of heuristics is matched by their potential for inaccuracy. They can result in cognitive biases and misconceptions since they’re based on a simplified version of reality and don’t take all aspects of a situation into account.
In a nutshell, the human brain was designed to survive, not thrive. We’re risk-averse by design.
In other words, our instincts evolved for survival, not rational thinking. We’re wired to avoid loss more strongly than we pursue gain. When money feels uncertain or emotionally charged, we default to irrational comfort zones like holding losing stocks or overspending windfalls to avoid uncomfortable feelings.
Mental accounting and the endowment effect are closely linked to another cognitive bias known as loss aversion, where giving up an owned object is considered a loss, making it more emotionally painful than gaining something of equal value. This can result in excessive caution, avoidance of beneficial risks, and emotionally driven decision-making.
Recognizing these mental traps is the first step toward neutralizing them. The next step is re-centering your decisions around your larger financial goals. At the end of the day, what are you trying to accomplish? In the case of the stock market, does waiting for a stock to return to its purchase price serve your long-term plan, or is it just an arbitrary comfort number?
To put it bluntly, investing doesn’t always feel good. Market downturns are uncomfortable, but discomfort doesn’t always mean you’re doing something wrong. Our brains evolved to react to immediate threats and rewards, which can work against long-term financial health. Market volatility might elicit an emotional response that’s opposed to the patient and adaptable attitude necessary for successful investing.
To get past these biases, focus on what your goals truly are. Look at the health of the broader economy and your own financial plan, not just the day-to-day numbers and knee-jerk reactions.
Once you understand how your brain influences financial decisions, you can start to outsmart your biases and make choices with greater clarity. That’s the foundation of Rational Finance.
Rational Finance is a framework that helps people make decisions based on what they truly want rather than what their subconscious fears or habits might be steering them toward. It’s about replacing emotional reactions with thoughtful, intentional strategy.
Rational Finance sits at the intersection of behavioral finance and mathematical strategy. By acknowledging that we’re driven by emotion, instinct, unconscious biases, and sometimes even anxiety when making money-related choices, we’re able to work with human behavior rather than against it.
It starts by getting clear on what matters most to you. What kind of life do you want to live? What are your goals? Why do you want to be wealthy? Understanding your motivations is the foundation of your rational financial plan.
Next, prioritize what’s most important. What are you able to accomplish right now? What current goals matter most right now? Notice when emotions like excitement over a windfall or frustration over losses start guiding your choices. Treat inheritances or bonuses as earned income by assigning them a specific goal or investment purpose. Remember that every financial decision should connect back to your overarching ideal life.
Thirdly, match your financial strategies to your objectives. Use financial analysis tools to align your cash flow with your targets. Partnering with a holistic financial advisor such as at PFW Advisors can help you find the best tools, strategies, and skills to align your money with your goals. They can also help you spot your cognitive biases and become aware of them so that you can start catching them.
When market headlines turn red, it’s easy to assume the worst. But short-term swings in the DOW or S&P 500 don’t necessarily reflect the economy’s overall health. The stock market and the broader economy often move out of sync. What looks like a downturn in one may simply be a temporary correction in the other. Focusing on fundamentals like corporate earnings, GDP growth, employment trends, and consumer spending gives a clearer picture of long-term potential.
A bad down market with good fundamentals doesn’t feel good to invest in, but it’s actually more appropriate than the other way around.
The stock market doesn’t always reflect the economy as a whole. There is a disconnect between short-term market fluctuations and long-term outlook. Many investors make the mistake of buying when the DOW is high and selling when it’s low, which is the exact opposite of what long-term strategy calls for.
Keeping perspective on the big picture helps you make rational decisions rooted in data and strategy rather than emotion.
Your brain’s decision-making shortcuts aren’t flaws; they’re survival mechanisms. But in the world of investing, they can cloud judgment and quietly derail progress. By understanding biases like mental accounting and the endowment effect, you can make more objective, goal-driven financial choices.
At the end of the day, every dollar, whether earned, gifted, or won, has the same value. How you treat it determines how well it works for you.
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