The Power of Mental Accounting

If a radioactive spider bites you, you might have one set of superpowers. If you get up, put your pants on and make gold records, you probably have a different superpower. For the rest of us, we get mental accounting as our superpower.  Cue the enthusiasm.

Mental Accounting 101

Mental accounting is a concept from the world of behavioral economics. At its core, mental accounting involves treating money differently based on arbitrary categories we create in our minds. For instance, you might treat $100 won playing 4, 5, 6 from $100 of basic pay from defending democracy, even though it’s $100 regardless.

We think of money in retirement accounts as different from money in checking accounts, but except for some IRS rules, they’re all just dollars.  Some of us like all our dollars in a single checking account for monthly spending, but try to keep track of which dollars need to be available for groceries and which dollars are for soccer team dues.  Others skew towards a Dave Ramsey style envelope scheme, perhaps using bank accounts as electronic envelopes, bins, or buckets to keep dollars separate for separate missions.

Mental Accounting Pitfalls

Mental accounting can add needless friction to your financial world. If you only fund an IRA with a tax refund, you rob yourself of monthly cash and time in the market, but you also must wait a year and manually contribute to the IRA rather than harness the power of automatic investing.

If you merge short, medium, and long-term goal dollars all in one investment account, you’ll have to continuously revisit, “How many dollars are for the car purchase vs. house down payment vs. daughter’s wedding?” to optimize asset allocation.

Mental Accounting (super)Powers

It’s unlikely that you think about your grocery budget the same way you think about your retirement income needs or the cost of college. These requirements have different time horizons and while we all need food, we can often produce different ways of funding college and retirement.

We can use mental accounting to intentionally separate dollars out by:

  • Mission or goal
  • Time horizon
  • Risk level for investment asset allocation
  • Account type for tax efficient

While it’s possible to over-optimize using mental accounting, most of us have needs that compete with each other such as:

  • Groceries
  • Clothing
  • Repair bills
  • Vacations
  • Future car purchase
  • Weddings
  • House down payments
  • College funding
  • Gifting & giving
  • Retirement
  • Long-term care

If the dollars for all these financial missions live in one account, we’re committing some unforced errors.

We can intentionally apply mental accounting by literally also creating separate accounts for dollars that have different and competing goals.

Food is mandatory and bought imminently. We don’t want those dollars getting comingled with the car purchase fund.

Retirement is a long way away (for most of us) and we need to take appropriate risk while signature-managing the tax man.  That’s not a good fit for our emergency fund.

Finally, mental accounting isn’t just about segregating dollars and restricting spending—it can be permission too.  If you use a separate account for stockpiling vacation funds, a growing balance is a green light to go and make memories.

Cleared to Rejoin

Mental accounting isn’t optional.  We all do it as we make decisions about how to save and spend. It’s parasitic drag on the wings if we don’t realize it’s happening. It’s a superpower when we deploy it organize our dollars by goal, time horizon, risk profile, and account type.  Put on your cape and do some mental accounting today. (Or just wear the same clothes you’ve got on. That works too.)

Fight’s On!

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