Behavioral psychology and personal finance
This is the fourth article in our behavioral psychology series by Jonathan Walker, Co-Author of Anchors, Ostriches, and a HotPair of Scissors: Navigating Human Behavior as a Financial Professional. In this series Jonathan will help you understand how your brain deals with personal finances. Understanding these principles will help you manage your money and possibly avoid common but costly mistakes. Here is the full series:
- How to recruit your brain to help with better personal finances
- When being hot can hurt your personal finances
- How doing nothing can blow up your personal finances
- How to use mental accounting to improve your personal finances
- How too many choices can ruin your personal finances
- How anchoring can hurt your personal finances
- How an ostrich can destroy your personal finances
How to use mental accounting to improve your personal finances
It may sound like only people who are really good with numbers do “mental accounting,” but the reality is that every single one of us do what behavioral psychologists call mental accounting. In fact, it can be a powerful tool for financial improvement or a way to make bad financial decisions. The key to mental accounting is learning how to use it to our advantage.
What is mental accounting?
Mental accounting is a concept in behavioral economics that describes how each one of us mentally categorizes and assigns value to our financial resources based on subjective factors.
Instead of treating money as an interchangeable asset, we create separate mental accounts for different funds or financial goals. This can result in suboptimal decision-making; we might prioritize one account over another even if it hurts our overall financial well-being. For example, we might spend unexpected income instead of saving it, because we treat it as “extra” money.
Understanding mental accounting biases can help us make better use of our financial resources and avoid costly mistakes.
5 Ways mental accounting can hurt your personal finances
Here are five ways that mental accounting can have negative implications for your personal finances:
- Suboptimal resource allocation: By mentally segregating money into different accounts or categories, you could overlook the bigger picture of your financial situation. This could lead you to make decisions that don’t help in accomplishing your long-term goals. For example, you might spend unexpected income because your brain considers it “extra” money instead of focusing on saving for the future or paying of debt.
- Overvaluing sunk costs: Mental accounting can cause you to overvalue sunk costs, which are past expenses that cannot be recovered. This could lead you to hold onto poor investments or stick with financial commitments that are no longer beneficial. By fixating on the past investments rather than the current or future value, you may miss opportunities to make better financial decisions.
- Inefficient use of windfall gains: When you get money you weren’t expecting (like a sales bonus, tax refund, or inheritance), mental accounting biases could cause you to use these poorly. You may take this “extra” money and splurge on short-term wants, instead of using them to help you meet long-term financial goals, such as saving for emergencies or investing in retirement. Instead of making your financial life better, it can slow your progress toward financial stability and wealth creation.
- Failure to optimize debt repayment: Mental accounting biases can also affect how you approach debt repayment. For example, you may see debt payments as “normal” expenses and do very little to accelerate their payoff. When a debt payment becomes a normal mental account, you fail to look for ways to make extra principle payments. This can lead you to spend money left over from your monthly budget rather than pay down extra principle with it.
- Ignoring opportunity costs: Mental accounting can cause individuals to overlook the cost of not making a particular decision in your finances. By mentally separating funds and treating them differently, individuals may miss opportunities to invest or use the funds in a more productive manner. For instance, keeping large amounts of money in low-yield savings accounts because you decided that account is for a particular purpose, even though moving those funds into a longer-term investment would have been better off for you.
To avoid the negative impact of mental accounting on your finances, you should occasionally step back and look at the bigger picture of your finances. You should…
- Consider your overall financial picture
- Prioritize long-term goals
- Reevaluate how you have separated your money
- Make decisions based on the best use of available resources
By adopting a more comprehensive mindset, individuals can make more informed and optimal financial choices.
6 Ways mental accounting can help your personal finances
While mental accounting biases can have negative consequences, there are also ways you can use mental accounting to improve your personal finances.
Here are six ways that mental accounting can help your personal finances:
- Goal-based saving: Mental accounting can be beneficial when it comes to setting and achieving your financial goals. By mentally separating funds for specific purposes, such as saving for a down payment, emergency fund, or vacation, you can maintain focus and motivation. This can help establish disciplined saving habits and ensure progress towards the goals that matter most to you.
- Budgeting and expense tracking: Mental accounting can help you budget and track expenses. Categorize expenses and plan your income to match those categories. This can help you understand your spending patterns better and help you identify ways you can improve. This can make your budgeting more effective and your spending more purposeful.
- Predicting the unpredictable: Mental accounting can also help you to avoid unexpected expenses. By setting aside funds for insurance premiums, health expenses, or retirement savings, you can plan for the unpredictable. This can help you avoid the financial pain of unexpected expenses.
- Hints and nudges: Mental accounting can serve as a nudge to encourage you to make positive decisions. Nudged regularly and you develop constructive financial habits. For example, setting up a specific savings account and automate the monthly transfer into that account can help prevent overspending. This give you consistency in your saving.
- Emotional well-being: Mental accounting can be a way to give you peace of mind. Knowing that specific funds are allocated for different purposes can reduce the anxiety you feel around finances. It can decrease your uncertainty and help you to feel more secure about your financial future.
- Simplified decision-making: Mental accounting can simplify your financial decision-making. By breaking down complex financial situations into smaller, manageable decisions, what was complicated becomes easy. Chopping up these complicated decisions into smaller choices can make personal finances more approachable. You can turn your hard financial decisions into easy financial decisions. For instance, mentally separating money for monthly bills, discretionary spending, and savings, you don’t have to repeatedly calculate how much money you have for spending.
To make the most of mental accounting and leverage its benefits, it’s important to strike a balance between separating your money into too many small categories and seeing the bigger picture of your financial life. Review your mental accounting regularly and adjust your finances to make sure you are always on the path to a stronger and better financial life.