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Saturday, July 13, 2024

How mental accounting can impact your portfolio

What is mental accounting?

Mental accounting occurs when you put a different value on money because of how you got it or where it comes from. It can create a bias that promotes financial decisions you wouldn't normally make — and that aren't necessarily the right options for financial stability and long-term savings and investment goals.

Find out more about mental accounting below. You'll learn about why it happens, how it can create bias in your financial choices and how to avoid it.

What is mental accounting?

Mental accounting was defined by Richard Thaler, an economics expert and professor, in 1999. He said it was a set of mental operations that people perform to track and make decisions about financial activities in their lives. 

There are some basic premises to mental accounting that include:

  • The fact that all money is, in fact, the same. No matter where the dollars come from or how you treat them, they are still dollars and provide the same value in your accounts and wallets.
     
  • People can have mental accounting bias. When you use mental accounting, you can rely on and create biases about money in your head, treating it differently depending on external and internal factors — even though the money itself is the same.
     
  • Windfall situations often drive more bias. When people receive a large amount of money, such as through a tax refund or inheritance, they often treat the money very differently than they would if they had earned the money through work.

Why mental accounting happens

Every person has an implicit accounting system, which is their mental system for accounting for money in their lives. These implicit systems govern how you spend your money, even if you aren't aware of it. Each time you pull out your debit or credit card or hand cash over from your wallet, you are making a mental decision that the value of the thing you are buying is worth the value of the money you're handing over.

Not every person has a written or recorded accounting system and budget, though. When you don't have a robust personal accounting system, you might default to mental accounting all the time. This can be a bad situation because it leads to your spending being ruled entirely by mental biases — many of which you might not be aware of.

However, mental accounting can occur even when you do have a personal accounting system in place. Some reasons mental account occurs in such situations include:

  • People label money in different ways. All money is the same, but we perceive it differently when we put labels on it. Money received as a gift for a birthday, for example, might be seen as "fun money" that you're supposed to do something frivolous with. Your bonus at work might be perceived in a similar way, even though it's part of your compensation package. By labeling money in these ways, you pave the path for mental accounting biases.
  • Framing principles affect outlook. Depending on how a situation is framed, gains and losses might be perceived in different ways that can lead to various mental accounting scenarios. For example, you might have a budget of $50 to buy shoes for your child. While you're at the store, however, you see that a pair of shoes that normally costs $100 are on sale for $70. People often choose to spend more than what they budgeted in such cases because they are saving even more than they are spending in excess.
  • The situation can alter how deals are perceived. If you're at the grocery store, you expect to pay a certain amount for various food items, for example. But when you're in a restaurant or at a county fair, you will pay much more for food and call it a good deal. 

Understanding mental accounting

Mental accounting can lead to illogical decisions about money. For example, you might be paying off debt, taking a certain portion of every paycheck to do so as you live a more frugal lifestyle to compensate for this endeavor. But when you get your tax refund, mental accounting might lead you to treat that windfall separately from your regular income. It would make sense for you to take your tax refund and put it on the debt to pay it down faster, but you might decide instead to splurge on a new television or pay for a vacation with that money. If you were treating all money the same, you might not make that decision. 

Examples of mental accounting

To better understand mental accounting and how pervasive it can be, consider some of the examples below.

  • Gift money. Often, people give money with the intent that you do something enjoyable with it. This can lead to treating this money in a way you wouldn't treat other money. You may splurge on an expensive meal or use the money for a purchase without shopping around to get a great deal.
  • Found money. If you find $20 on the ground, this feels like money that doesn't "really exist" in your budget. In reality, it could be added to the grocery store budget or used to pay for a small internet streaming bill. Many times, however, people who find money use it on something they wouldn't normally purchase.
  • Inheritances. It's a common worry that people who inherit money might spend it all quickly and illogically. This is why many people set up trusts to control how assets and money can be used by beneficiaries. The reason many people use inherited money in somewhat reckless ways is that they are relying on mental accounting.

Other sources of money that can lead to mental accounting include bonuses at work, tax refunds and large profits from the sale of property such as a home or car.

Mental accounting bias in investing

Mental accounting can also impact the way you manage your financial portfolio. For example, some people divide their investment money into "money they can afford to lose" and money they really can't. The latter is invested carefully and with an intent to reduce risk, even if the gains are slow or small. The former is sometimes invested with extreme risk because there is a mental accounting bias that says the money can be lost, and it won't be as big a deal. In reality, of course, all money is valuable and should be invested with at least some amount of care.

How to avoid mental accounting

You can avoid mental accounting by treating all money the same and planning ahead to manage it. 

Create a household budget

Start by creating a household budget that regulates how you spend money. If you're sticking to a household budget, you won't automatically spend any found, gifted or windfall money because you're buying things in accordance to rules you set up when you were able to consider all money the same. Sticking to a budget also helps keep you from overspending just because you perceive something to be a good deal in the moment.

Plan for unexpected income

Include plans in your budget for unexpected income or windfalls. You don't have to be so strict that you can't have fun or use gift money for fun things. But you can set some expectations and rules to help you value money equally, no matter how it comes to you and what circumstances you find yourself in. For example, you might say that 50% of all gifted money you receive can be used for fun things, while half of it should go to savings. Or you might make a budget rule that 30% of bonus or tax refund money every year goes to savings, 50% goes to debt and 20% goes to something fun.

Our take

Managing your finances well over time requires clear goals and budgets. When you set rules for how you spend and treat money, you can avoid the problems that come with mental accounting biases. Build a portfolio and manage money to create a more stable future.

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Daniel Kuhl

Contributor

Daniel Kuhl is an Insurance Specialist at Empower. He is responsible for providing clients and advisors with robust insurance advice and analysis.

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