If you've ever heard friends say that they can't spend a certain pool of money because they're planning to use it for their vacation, you've witnessed mental accounting in action. Most of us separate our money into buckets--this money is for the kids' college education, this money is for our retirement, this money is for the house. Heaven forbid that we spend the house money on a vacation.
Investors derive some benefits from this behavior. Earmarking money for retirement may prevent us from spending it frivolously. Mental accounting becomes a problem, though, when we categorize our funds without looking at the bigger picture. One example of this would be how we view a tax refund. While we might diligently place any extra money left over from our regular income into savings, we often view tax refunds as "found money" to be spent more frivolously. Since tax refunds are in fact our earned income, they should not be considered this way.
For gambling aficionados this effect can be referred to as "house money." We're much more likely to take risks with house money than with our own. For example, if we go to the roulette table with $100 and win another $200, we're more likely to take a bigger risk with that $200 in winnings than we would if the money was our own to begin with. There's a perception that the money isn't really ours and wasn't earned, so it's OK to take more risk with it. This is risk we'd be unlikely to take if we'd spent time working for that $200 ourselves.
Similarly, if our taxes were correctly adjusted so that we received that refund in portions all year long as part of our regular paycheck, we might be less inclined to go out and impulsively purchase that Caribbean cruise or flat-screen television.
In investing, just remember that money is money, no matter whether the funds in a brokerage account are derived from hard-earned savings, an inheritance, or realized capital gains.