Mental accounting. It’s a bias that can keep you so caught up in the trees, you miss the forest. So focused on the details you miss the bigger picture they paint. It’s why people treat an annual bonus differently than the rest of their earnings or overspend while on vacation. And it can add up to trouble for your financial goals.
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, it’s nowhere to be found. What if it were the cash in your pocket that had gone missing? Would you be inclined to spend additional money to replace the 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 were cash they lost.1 Even though the two scenarios are effectively identical, our brains tend to treat them in completely different ways.
70% of winners of lottery windfalls end up bankrupt, and the more they receive, the likelier they are to go broke. Source: CNBC, Don’t fumble a financial windfall: Plan a strategy
Mental accounting hinges on the idea that all money is interchange- able, but we frequently fail to treat it that way, leading us to sort our assets into distinct “accounts” both figuratively and literally.
For example, the tendency to treat windfalls 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 NFL players have depleted their mammoth fortunes within just three years of retiring from the competitive field.2
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.”
33% of people – and 50% of millennials – plan to use their tax refunds to pay for travel. Source: Detroit Free Press
Mental accounting is one of the surest ways to keep a financial plan from reaching its full potential. While it’s important to pay attention to the little things, remember that sometimes the most important step toward achieving your long-term financial goals is taking a step back. Leverage tools from your financial institutions that provide a comprehensive view of your various accounts and can help you better clarify your financial needs and goals.
Just as important is ensuring you have a reliable source of objective information and guidance. Seek out the perspectives of people whose beliefs differ from your own and professionals with specialized expertise. As your financial advisor, I can serve as an unbiased third party, offering the perspective you need as well as comprehensive financial planning guidance to help you move toward your future with confidence.
To help you keep mental accounting from derailing your financial plan:
1Psychology Today, Mental accounting and self control