What is mental accounting?
Mental accounting is the tendency we sometimes have to treat the same thing – money, in particular – differently depending on where it came from or what we intend to do with it.
Consider this scenario: You buy a movie ticket in advance, but when you arrive at the theater, you discover you’ve lost it. Now consider instead that you planned to buy your ticket at the box office and it’s the cash in your pocket that goes missing. Would you be likelier to spend additional money to replace the lost ticket or to “replace” the lost cash.
A study that posited exactly this situation found that just 46% of respondents would spend additional money to replace a lost movie ticket – since they’d already spent the money they’d mentally accounted for that purpose – but 88% would spend again if it was cash they lost.1 Even though the two scenarios are effectively identical, our brains tend to treat them in completely different ways.
Mental Accounting = Missed Opportunities?
Mental accounting hinges on the idea that all money is fungible, or interchangeable, but that we frequently fail to treat it that way, leading us to sort our assets into distinct “accounts” both figuratively and literally.
The tendency to treat windfalls, for example, differently is one of the greatest threats mental accounting can pose to your finances. You see it in the incredible rates at which lottery winners end up bankrupt or how 80% of professional athletes have depleted their mammoth fortunes within just three years of retiring from the competitive field.
But mental accounting also operates on a smaller scale, leading people to do things like spend an unexpected inheritance on a luxury purchase instead of saving it like they would other income. Or to shortchange their long-term goals because they’re too focused on the short-term performance of one particular “bucket.”
When mental accounting factors into your financial decisions:
- You might undercut your financial progress by treating certain inflows (bonuses, tax refunds) as more “spendable” than others (like your regular paycheck).
- You might lock in losses if you’re saving money in low-risk vehicles but paying a higher interest rate on any form of debt.
- You might miss out on gains if you’re paying off low-rate debt faster than necessary when you could receive a better return by investing that money.
- You might trigger the wash sale rule (which applies across your accounts as well as your spouse’s) if you sell a security for the tax benefit in one account but unwittingly repurchase a substantially identical security in another.
Mental accounting is one of the surest ways to keep a financial plan from reaching its full potential. Fortunately, it doesn’t have to keep you from seeing the big picture of yours.
Break out of mental accounting
- 1. Treat money with the same careful consideration no matter where it comes from or how you plan to use it.
- 2. Take a step back, at least periodically, to look at your overall financial picture. Leverage tools from your financial institutions that provide a comprehensive view of your various accounts.
- 3. Don’t let external circumstance affect good money habits. Enjoying a well-deserved, saved-for vacation shouldn’t mean relaxing your spending standards in ways you could regret once you’re back home.
- 4. Don’t interrupt your financial progress by changing spending habits based on one “bucket’s” short-term performance – a good day in the market shouldn’t lead to a luxury purchase you would have otherwise delayed.
- 5. Talk with your children and heirs about what it took to build your wealth and what your wishes are for its future, so when the time comes to pass it down, they don’t see it as a "lottery win" and misspend.
- 6. Look for help. Seek out the perspectives of people whose beliefs differ from your own and professionals with specialized expertise. In the case of your financial future, it helps to work with an objective third party – like an experienced financial advisor – who can offer perspective in addition to wealth planning and investment support.
While it’s important to pay attention to the little things when it comes to your finances, don’t let the pieces make you lose sight of the whole. Remember that sometimes the most important step toward achieving your long-term financial goals is taking a step back.