Imagine you receive a lottery ticket worth $100 in a birthday card. Are you more likely to spend that money or to stash it in your IRA? Most people would spend it, and that’s because of mental accounting.
Mental accounting is the habit of assigning different jobs to money depending on its source. This habit of mind can work for us or against us, depending on how we use it.
Where Does Mental Accounting Show Up?
Mental accounting is the term we use to describe the way we assign different meanings (and therefore purposes) to money depending on how it came into our hands.
If we earned the money, we are more likely to put it to practical uses. If it was won, found, or given to us, we are more likely to spend it for enjoyment. If it was the result of a tragic loss, we may avoid it or even give it away.
Mental accounting is a shortcut that our brains use to try to make sense of things and assign meaning and order to the world, but it is often emotionally driven and can lead to illogical, or even damaging, decisions. With that in mind, it’s good to know where to be on the lookout for it. Here are a few places to look.
First, windfalls. Any time you receive unexpected money, you’ll be likely to want to spend it more frivolously than you would your paycheck. Maybe you get a bonus at work, a tax refund, a gift, or a small lottery win. Whenever money comes to us that we hadn’t planned for, we are more likely to see it as “extra” money or “fun” money, and to spend it accordingly. In doing so, we may be neglecting our emergency funds, the interest on our credit cards, and our retirement savings. However, an unexpected windfall, even a small one, can put you that much closer to financial independence --yet mental accounting has us thinking that we should use the money right away, and the more frivolously we spend it, the better.
We see it every spring when stores start urging people to put their tax return toward a new car, TV, or other luxury item. Retailers know that people treat their tax returns as spending money, so they tailor their ads toward that tendency.
Another place where mental accounting is a problem is when the source of the money is painful. This can happen when people receive an inheritance or an insurance settlement after a tragic accident. If you have mentally tied that money to the person you lost, or to the tragedy itself, you may have a lot of trouble making good decisions with it.
Recently, I met a man who lost his mother. He received an inheritance and is deeply troubled by it. He is considering just giving it away, despite the fact he has financial needs. The problem here is that he has associated the money with his mother’s legacy, and so he wants to make it “mean” something worthy of that legacy. Using it to pay his bills doesn’t feel worthy of her memory, even though that is probably the very thing she hoped he would do.
Similarly, financial advisors have told me stories of people holding on to shares of stock simply because their loved one was the one to pick it out, and so to sell it would be like losing a little more of their memory. Some people feel guilty using money they’ve inherited because they can’t stand the thought of getting pleasure or comfort from the loss of their loved one.
Working to separate the grief from the gift is not easy, but it is beneficial. This is one of the reasons why financial advisors often tell people to leave an inheritance untouched for at least six months.
How to Use Mental Accounting to Your Benefit
You can use mental accounting to your advantage by adjusting your thinking just a bit. What if, instead of seeing that tax return or bonus as “extra money” and using it as a slush fund, you gave it a different job? You could look at that check as a head start on a down payment for a house. You could see it as an extra cushion in your savings account for when your car breaks down (it will) or you have an unexpected large expense come up (again, you will).
Try redefining found money as found security. It’s an unexpected lift to your net worth, however small. It’s extra safety. Found support. It’s money you didn’t plan on having, which means you can probably afford to save it. Making a habit of saving money that comes to you unexpectedly could make a big difference in the long run.
What if, instead of seeing an inheritance as a living memory, you thought of it as a way for your loved one to support you, even in their absence? After all, that is what most financial gifts are intended to do.
Another way you can use mental accounting to your benefit is to assign a job to your money, rather than just leaving it in an account where you might be tempted to spend it. You’re less likely to spend money that you’ve earmarked for your child’s education, for example, than money with no clear purpose. By assigning a job to your money, you create a barrier to spending it on anything other than that purpose because to do so would mean taking money "away from" the original goal. To spend it on anything else, you have to move it from one mental account to another.
Easy come doesn’t have to mean easy go. Just because money may have come to you without effort doesn’t mean you should let it slip away. Likewise, money from a loved one’s death doesn’t have to forever be tied to grief. When you know what to look for, you will start to see mental accounting in your own life, and you’ll start to hear it in the way others talk. Like many of the mental shortcuts I’ve talked about, this one can be a help or a hindrance. Investing just a few seconds of effort to mentally reassign money to a different purpose can lead to healthier financial decisions--and a healthier bottom line.