In an age where opening a banking or brokerage account is as easy as logging onto the internet and entering a few lines of personal information, mental accounting has become more than just a behavioral bias; it is now being used incorrectly as personal finance tool. Now you are probably asking yourself, what is mental accounting? I’ll admit that when I first heard the term my thought process was a bit off. It went something like this:
- Mental = Using Your Brain = Good
- Accounting = Math and Business = Good
- Therefore Mental Accounting = Good + Good = Excellent
When I actually learned about mental accounting I was surprised to find out that it is really was just a definition for something I already did and have seen many others do. When I was at Northwestern mutual I learned about the “bucket theory”, and how I could use it to explain to clients the need to divide up their money into different “buckets” to fulfill different financial needs such as necessities (food, shelter, etc.), emergency savings, insurance, and retirement savings. While the “bucket theory” isn’t the same thing as mental accounting, it involves a similar thought process that can be detrimental to your overall financial picture if you don’t understand the difference.
What is mental accounting?
Mental Accounting is the tendency to separate money (or debt) into separate accounts (mental or actual) based on varied subjective criteria like the purpose for the money or the source of the money. Banks like Capital One 360 are now supporting mental accounting by allowing users to separate their money into multiple “separate” accounts automatically when they receive a paycheck. Separating your money by purpose may be a helpful way to budget for the things you want; however, this may be keeping you from seeing your entire financial picture.
Examples of mental accounting include putting money in a separate savings account for vacation, putting money into an emergency fund while holding onto high interest consumer debt, or spending the tips you receive while only depositing your paycheck in your bank account. For more on the definition of mental accounting check out Investopedia.
Why is mental accounting bad?
Separating money based on where it came from or what you are trying to accomplish with it may seem like a good idea. In fact, given this definition it may seem like setting aside savings for a down payment on a house, saving for your child’s education, saving up for a wedding etc. are examples of mental accounting. The difference between saving for life goals such as these in separate accounts and succumbing to mental accounting is that mental accounting involves viewing a sum of money separately from other money. To exemplify how mental accounting can hurt you I have put together a few examples below:
- Spending your tax return on a new car payment instead of putting it towards your credit card debt
- Using your larger than expected year end bonus to buy a boat instead of contributing more to retirement savings
- Investing part of your money in traditional mutual funds while putting another part in speculative stocks in order to maintain the possibility of “hitting a home run”
- Dropping a burger you purchased and then purchasing another while only placing one burger purchase entry in your budget (the dropped burger is treated as lost money instead of part of your budget)
- Saving money in a low interest savings account instead of paying off high interest debt
- Spending winnings from gambling frivolously and not counting those winnings against your financial plan
So what do all of these examples have in common? They show how mental accounting can cause you to view portions of your money as being exempt or separate from your overall financial plan. Remember that regardless of where the money you earn comes from, it is still your money, and deserves to be looked at through the lens of your financial plan.
What is the difference between the “bucket theory” and mental accounting
The “bucket theory”, where you set aside money into different “buckets” for different financial goals, is a way to help people understand how they should allocate their financial assets and risk (“allocating” financial assets and risk is just a complicated way of saying “split up your money and risk protection between different things such as savings accounts, debt payments, stock mutual funds, bond mutual funds, or insurance). The difference between the bucket theory and mental accounting is that the bucket theory forces you to look at your financial assets, debts, and risk in one big picture with multiple parts, while mental accounting is the practice of separating out sums of money from the big picture based on how you acquired the money or what the money is purposed for.
Make sure you don’t get bucket theory mixed up with mental accounting, as this may cause you to make poor decisions with your money. Having different buckets of money is good as along as all of those buckets are working together to help you accomplish your overall financial goals. Be on the look out for “buckets” that are not actually helping your overall financial picture, such as a vacation savings account earning zero interest when you have credit card debt costing you 20% per month. These are not really buckets but simply mental accounting snakes waiting in the brush to bite!
How to avoid mental accounting
Remember, no matter where the money came from or what it will be used for, it is still money and should be subject to your financial plan. Also make sure that you look at debt as a negative investment and not just a monthly interest payment. Debt is not just something that creates a monthly payment, it is an amount of money that you owe to someone else and it will have to be paid back, typically including interest. Looking at your finances as a whole will help you spot mental accounting and end it before it ends up costing you money.
If you are interested in other behavioral biases beyond mental accounting, check out “Is Investing Like Gambling?”