The phrase mental accounting sounds like it’d be a great thing. Who wouldn’t want to balance their checkbook with absolute precision completely in their head? In reality, mental accounting can be a dangerous financial trap to fall into. Mental accounting refers to people’s tendency to categorize or bucketize their money based on either the source of the income or an arbitrarily assigned purpose for specific funds. While this might not sound terrible, it can create issues in the way money is spent. Essentially, mental accounting leads to abnormal or illogical spending patterns because of biases in the way money is viewed. Let’s take a look at some examples, as well as how we can avoid some of the financial craziness induced by mental accounting.
Free Money Fallacy
The Free Money Fallacy is one that I’m sure we can all relate to. Often times, windfall or unexpected money is just considered “free money” and is spent with more ease than a regular paycheck. This is especially apparent during tax season, as many of us are in a rush to receive our tax refunds, thinking of all the fun things that can be bought. The reality of the situation, however, is that this windfall money is exactly the same as earned money. (I won’t even get into the fact that a tax refund is actually earned money…) All money, is, in fact, the same and should be treated as such.
Windfall money, such as that tax refund, feels easier to spend because you haven’t prepared for those funds like you have with regularly occurring paychecks. Without a category assigned to the money, it’s considered found rather than earned and much easier to part with. That the income is unexpected, however, does not make it any less earned. Resist the urge to consider windfalls as free money and instead think of those large sums are speed boosts propelling you closer to your goals at a blazing pace. How, you ask? By putting a dent in your debt payment or investing in the stock market.
A Case Against Cash Envelopes
Budgeting may be a great tool for those who enjoy structure or are just starting to get their finances under control, but there are some fairly significant downsides as well. What happens when, due to your ineptitude in predicting the future, you overestimate how much you’ll need to spend on a specific category? Well, the ideal response would be to save and invest the difference, (then maybe do a little happy dance when no one is looking). What typically happens, however, is that you’ll spend more to fill up your budget for that category.
Consider the following example: Every month you budget $75 for restaurant dining. Not my thing, but I’m not here to judge you. With two days left in the month, you’ve only spent $40. Good for you! Except that, more than likely, you’ll feel entitled to fill in at least some of that difference. Despite the fact that you have plenty of groceries in your house and even some delicious leftovers from last night’s dinner, you decide you can make a Chipotle run on your lunch break. The next day, you grab some burgers on your way home from work. Between the two, you only spend another $20, still coming in well under your budget. You feel proud of yourself for undershooting your restaurant budget, but I’m here to tear down those vain feelings. (You’re welcome.)
Don’t get me wrong, both of these choices are delicious, but the motivation for those choices is what I’m questioning here. There was no need for those food runs. You were perfectly capable of feeding yourself with quality food in your home. In fact, those leftovers from last night’s dinner may now go to waste (shame on you!). The only reason you felt the need to go out to eat was that you had room in your budget.
This is where mental accounting can get you into trouble. Assigning portions of your money to specific categories gives you permission to spend money on things you don’t need. What if, while you were $35 under budget, you had an unforeseen car repair costing you $150? That extra space in your restaurant budget should have gone towards that added expense, but, because of mental accounting, it’s far more likely to instead fill in the gap for the assigned bucket.
This is why I recommend, at the very least, getting away from budgeting by category. Budgeting sets a maximum limit on how much you can spend, giving you the go ahead to spend more than you need to. Instead, challenge yourself each month to see how little need to spend to enjoy life. Thinking instead on the minimum you need to get by and start from there. Push yourself to make changes to steadily decrease your expenses.
A Few More Mental Accounting Examples
Abel receives $300 from his very generous grandparents every year for his birthday knowing that he still has some significant student loan debt to pay off. He tracks his income meticulously each month, but doesn’t factor in this extra cash during his tracking, because it isn’t part of his salary. In celebration, he invariably spends all $300 (and occasionally more) on an extravagant party. Abel is still in debt. Don’t be like Abel.
Bernice makes a decent salary and is contributing just under the employer match to her 401(k). She budgets $150 every month to a bucket she calls “Blow Money.” This amount, coincidentally, would put her over 5% limit that her employer matches, essentially costing her over $1,500 in lost wages from missing out on the match. Much of this “Blow Money” category is spent frivolously on either useless gadgets or nights out on the town (often resulting in miserable days following). Sustaining this “Blow Money” category throughout her life will require Bernice to earn another $45,000 at the job that she detests. Make better choices than Bernice.
Chad enjoys a bit of gambling from time to time (we won’t judge him for this, it’s mostly for the “free” drinks). Currently, he’s got a hot hand at the Blackjack table and is up a few hundred dollars. Chad is way ahead and this money came to him with such ease, he doesn’t feel he earned it. The good decision would be to cash out (maybe after he gets the drink he ordered) once he’d more than doubled his money. Instead, despite not yet having much to drink (where did that waitress get to anyway…), he starts to get a let loose with his betting feeling as though he’s playing with the casino’s money and not his own. This recklessness spills over past the amount he earned and he starts dipping into the money he originally brought, losing $75 on the night. Learn from Chad’s mental accounting mistake (and probably don’t gamble, to begin with).
Denise and her twin brother Edgar are going to the movies. Unfortunately, along with the same hair eye color, both of them have the same hole in their pocket. Denise loses the $10 bill she had been planning to use on the movie ticket. Edgar bought his ticket in advance, instead of the cash, lost his ticket. Aside from getting this family a sewing kit, what’s to be done?
Well, if Denise and Edgar are like the rest of the population, Denise will probably pull out another $10 and buy the ticket. Edgar, on the other hand, will hesitate and may choose to opt out of the movie, feeling the burn of the lost ticket.
In fact, 46% of participants in a study examining this situation said they would buy a new ticket if they were Edgar and had lost the ticket. In comparison, 88% of participants who put themselves in Denise’s shoes would be willing to go see the movie, even after losing the $10 bill.
Seem strange? Realistically, both of these outcomes result in the loss of $10. So what makes Edgar’s situation so different that nearly half of the sample would choose not to buy the ticket? The difference is that Edgar had already spent his $10 on the movie assigning that amount to the movie in his mind. Buying a new ticket would mean spending $20 to go to a movie. Denise, on the other hand, lost $10 of general funds. If she buys a ticket after losing the cash, she still is only spending $10 in her mind. In reality, both situations result in a loss of $20, whether that amount is assigned to the movie ticket or not is irrelevant on the bottom line.
Preventing the Adverse Affects of Mental Accounting
Being aware of the trap of mental accounting is the first step in dodging some of the irrational behavior that comes along with it. First, remember that all money is interchangeable and the essential same, regardless of the source or category assigned to it. Step away from assigning categories to your certain funds and instead focus on the value of each purchase independently. Always keep in mind the goals you are working towards and prioritize reaching those over precisely reaching each budget category or blowing $X on fun each month.
Money is Fungible
- (of goods contracted for without an individual specimen being specified) able to replace or be replaced by another identical item; mutually interchangeable.
Money, regardless of the source, is all the same. Where a dollar came from shouldn’t affect where it goes, nor should an arbitrarily assigned category. If you can begin to view all as fungible, you’ll be able to avoid many of the problems that arise with mental accounting. Salary income is no different than windfall income. Both can (and should) be put towards your goals, whatever they may be.
In the same way, money spent doesn’t have to come from a specific place. If for example, you have a separate savings account for home repairs but your car breaks down, nothing should stop you from withdrawing some of that house fund to pay for the car emergency. This is especially true if the alternative is to pay for the repairs on credit, costing you interest as a result. Bucketizing savings makes it harder to see available funds are interchangeable, however. Instead, set a general emergency fund to cover any and all potential catastrophes.
Consider Value not Categories
To prevent mishaps with mental accounting, consider the value of each purchase individually. Don’t take into account how much (or how little) you’ve already spent on a particular category when deciding whether or not to make a purchase. Instead, view each purchase as an independent event. This will allow you to make a more objective decision in whether a purchase is going to add value to your life, instead of just filling an empty slot in your budget.
Track Your Spending
Monitoring your financial habits is a great way to ensure that you’re not overspending as a result of mental accounting. Personal Captial is a free service that makes it easy to keep track all of your accounts. By viewing your net worth, income, and expenses in a single, visually appealing dashboard, you can make better decisions about managing your money.
Focus on Goals
Above all else, the best way to avoid any problems with mental accounting is to prioritize reaching your financial goals. This makes it easier to put money towards a purpose when an unexpected sum falls into your lap. Instead of viewing windfall money as easy to spend, you’ll see it as an opportunity to take a shortcut towards your targeted goal. The best thing you can do with unexpected income is to divert it away from your checking account immediately (into either a savings or investment account) so you don’t even have the opportunity to spend it foolishly.