Have you ever come out on top at a casino and decided to treat yourself to something extravagant? Did you spend your last tax refund on a vacation instead of paying down debt? Do you frequently dip into your savings but wouldn’t dare touch your 401(k)?
If any of these situations sound familiar, you might be one of many who has fallen prey to what behavioral finance experts call the mental accounting bias.
In theory, the situations above don’t make sense. Every dollar should be treated the same as every other dollar regardless of the source, a concept in finance known as the fungibility of money. However, we don’t treat our money that way in practice. Popularized by behavioral economist Richard Thaler, mental accounting can be defined as our tendency to treat various pools of money differently, depending on where the money comes from and how we intend to use it.
One of Thaler’s famous experiments on mental accounting bias does an excellent job of illustrating how it happens in the real world. In his study, Thaler asks participants to consider the following hypothetical scenario:
Imagine that you have decided to see a movie and have paid the admission price of $10 per ticket. As you enter the theater, you discover that you have lost the ticket. The seat was not marked, and the ticket cannot be recovered. Would you pay $10 for another ticket?
Only 46% of respondents said they would purchase another ticket. He then asked the participants to respond to another hypothetical scenario:
Imagine that you have decided to see a movie where admission is $10 per ticket. As you enter the theater, you discover that you have lost a $10 bill. Would you still pay $10 for a ticket to the movie?
This time, a whopping 88% said they would pay for another ticket!
What’s interesting about this case is that either way, you see an loss of $10. However, our tendency to put our money into mental “buckets” meant that in the first scenario, the moviegoer had already exhausted their Movie Funds—spending $20 on a movie ticket would be outrageous! On the other hand, the second scenario illustrated the existence of one mental bucket for General Spending, and one for Movie Funds. In this case, the loss of $10 in the General Spending bucket did nothing to deplete resources in the Movie Funds bucket. Illogical, no?
How Mental Accounting Hurts Us
When you create mental buckets of money, it can have damaging effects on your finances. For instance, mental accounting can lead us to:
- Throw away lotto winnings, birthday money, and raises on less important or more extravagant purchases rather than contributing it towards the long-term goals that matter most
- Delay needed purchases in one category because the budget ran out, but still spend money on other less useful items in different categories
- Keep too much money in a cash emergency fund rather than putting it to work in an investment account or paying down high-interest debt
- Avoid risks with our emergency fund, but overdo risk in our investment accounts, leading to suboptimal investment decisions across all the various groups of monies
Each of these examples illustrates a sub-par financial decision, either refusing to spend savings and earmarked money on the things we really need, or treating money that occurs outside of your budget as a bonus to be spent however you want. Either way, mental accounting results in a sort of financial inflexibility—an ability to adjust or goals or budget based on new financial information.
The Unsung Benefits of Mental Accounting
Making decisions based on “arbitrary” categories is no way to build an investment portfolio… or is it? Well, truth be told, there is perhaps a method to this madness after all.
Think of the last time you found yourself in a financial pickle. Where did you get the money from? Well, if you had an emergency fund, chances are you used it. If you didn’t, perhaps you had to spend more money than usual on your credit card. In fact, you’d probably have exhausted every available option before finally resorting to your children’s’ college fund or your retirement account—it was mental accounting that saved your future retirement!
Likewise, mental accounting can be an important part of the goals-based wealth management process. Goals-based planning emphasizes the use of investment portfolios that allow you to reach your goals, rather than targeting a specific rate of return. Because each goal has a different return requirement and risk profile, you would in theory use different types of investments to reach each goal.
In many ways, this “bucket” approach is similar to the pitfalls described above, but with a couple crucial differences:
- This approach is thoughtful and deliberate, in that it forces a conversation about what your goals are, the best way to reach them, and what to do if a goal becomes unrealistic.
- It helps cautious investors feel more comfortable taking on the risk they may need to reach their goals, since the most important goals are “assigned” the safest investments, whereas less aspirational goals may allow for investments with a higher risk and return profile.
- By having all your goals clearly articulated, it becomes easier to determine what to do in the event of an unexpected windfall.
We should note that it’s important to make sure that you’re looking at all those accounts in aggregate too, so that you’re not stuck with an underdiversified or inefficient asset mix. Either way, the same tendency towards mental accounting that leads to bad decisions may also keep you from spending the assets you need the most, as well as ensure that your portfolio is tailored to the unique risk and return needs of all your various investment goals.
Many investors suffer from mental accounting bias, but the question is: is it hurting you, or helping you?
If you’ve found ways to make it work to your advantage, congratulations! If you haven’t quite gotten there yet, we’ve got a whole team of investment professionals who can help ensure that your portfolio is aligned with your goals, that you have a plan for how to handle emergencies, and that you’re prepared in the event of an unexpected windfall.