What’s the easiest way to double your money? Take a $20 bill to the bank and ask them for two 10s.
Sounds like a bad joke, doesn’t it? But every year millions of Americans engage in a similarly nonsensical approach toward their finances. It’s called mental accounting – and it’s no joke.
Mental accounting is a term coined in 1999 by Richard Thaler, a professor of economics at the University of Chicago Booth School of Business, and refers to the “set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities.”
How we fall prey to a mental accounting bias
Instead of viewing all money the same, you may tend to think of your money differently depending on how you acquired it. This can often happen when you receive an unexpected financial windfall.
For example, getting a tax refund from the IRS is often viewed as “found money” as opposed to earned money from a job or small business. But in reality, that money is not a gift. The IRS is merely returning your own money to you, usually due to overpayment of taxes during the course of the year.
However, having a mental accounting bias makes it easier for you to spend that tax refund on discretionary items instead of using it to pay down debt or putting it into a savings account.
When you think you’re saving but you’re not
Another common situation in which mental accounting comes into play is when saving for a specific goal. You may have created a separate savings account or even a money jar in which to deposit funds from time to time in order to fund a vacation, a new car or another discretionary expense, while at the same time carrying a significant balance on high-interest credit cards.
But logically it doesn’t make sense to put money into a savings account that makes little or no return while credit card debt racks up double-digit interest charges annually. In this situation, the accruing debt on your credit cards erodes or wipes out the interest you make in your savings, and even worse, it reduces your overall net worth.
Mental accounting bias can adversely affect your investment decisions
Besides savings and budgeting, perhaps the place where mental accounting can have the biggest adverse impact on your finances is when it comes to investing.
Take for example an investor who needs to raise cash and has to choose between selling two different stocks: one with an unrealized gain and one with an unrealized loss. Seeking to avoid the pain of loss, the investor will often employ mental accounting. This can sway them toward selling the winning stock even though the more rational decision would be to sell the loser, as that stock is likely a weaker investment and the loss may benefit them on their taxes.
We all are guilty of using mental accounting in some way or another, but being mindful of it and changing our thought patterns is the first step in taking back financial control of our lives.
A strategy to combat mental accounting
You can negate the effects of mental accounting by accepting the underlying theory that all money is the same, regardless of how it’s acquired or what its intended use is. But that only goes so far.
The next step is to create a plan for what to do if you receive unexpected income like a gift, bonus or tax refund. For instance, you could put half of it toward debt, or if you don’t have any debt, into a savings account, and use the other half to splurge on something.
At Edelman Financial Engines, our experienced advisors can help you identify mental accounting as well as any other issues that might be adversely impacting your financial and retirement planning. Give us a call today at (833) PLAN-EFE.