Investors value money differently based on their experiences, goals and beliefs. This process is known as mental accounting, and it often affects how we budget and spend our money. Mental accounting can also affect our investment decisions, leading us to make choices that make it harder to meet our goals. Learn more about mental accounting, including how it applies to finance and whether or not you should use it to make decisions.
Mental accounting describes how two similar people choose to spend their income based on how each person values money differently. In many ways, these criteria are subjective, and investors weigh each of the categories differently, which complicates the topic even further. Sometimes, mental accounting is detrimental and can make it harder for investors to reach their financial goals. This can happen when people view money decisions in relative terms instead of absolute terms.
Behavioral economists study the concept of mental accounting and how it affects our financial decisions ranging from daily spending to long-term investing. The concept was defined by famed economist Robert H. Thaler.
How to Use Mental Accounting in Financial Planning
Mental accounting
In mental accounting, people treat money differently based on where it came from and how it is supposed to be used instead of treating every dollar the same. With investing and budgeting, people can treat their money differently in many ways. Here are a few examples:
Tax Refunds
Although a tax refund is getting a portion of the money withheld from your paycheck, many people view it as found money. They don’t always respect the time and effort it took to earn that money and, instead, feel that they can splurge when they get a refund. The money, which amounts to an interest-free loan to the government, may be used to fund a vacation, buy a big-screen TV or fund another purchase that they normally wouldn’t make.
If this happens to you, adjust your withholding rates to reduce your tax refund. This will give you extra money in every paycheck. Or consider using the money to build your emergency fund or contribute to this year’s Roth IRA.
Inheritance
When a loved one passes away, you may receive an inheritance from their estate. Since you didn’t work for the money, it is easy to treat it as extra money that can be used on frivolous purchases. While your loved ones want to see you happy, a better choice is to invest that money to secure your retirement or a college education for your children. Other good choices include paying off high interest debt or saving for a down payment on a house. Being happy with your choices and building a stronger financial future is a great way to celebrate your loved one’s memory.
Employer Matching Contributions
Many companies offer a matching contribution when you contribute to the company’s retirement plan. Some investors don’t respect how much these extra contributions can propel them toward their financial goals because it doesn’t come from their paychecks.
When a company doesn’t offer an employer match, some investors choose not to contribute to the retirement plan. Contributing to a Roth or traditional IRA instead can be a good choice, but their annual contribution limits are much lower. Once you’ve maxed out those accounts, contribute to your company retirement plan, even if your employer doesn’t offer a match.
Paycheck Increases
Annual merit increases seem small when they average 3% to 5% in most years. While the dollar increase to your paycheck can be small in any one year, those increases magnify over time because of compounding interest.
When you receive a raise, use some of it to increase your retirement plan contributions. This action builds up your investment accounts and accelerates your path toward your financial goals. And, if you continue to increase your contributions each year, you’ll soon be maxing out your annual contribution limits without ever reducing your take-home pay.
Savings and Checking Accounts
Some investors view the money in their checking and savings accounts differently. They view checking account balances as money that’s okay to spend, while savings accounts are intended for a “rainy day.” To combat this thinking, have your paycheck direct deposited into your savings account. Then transfer money as needed to pay your bills. This strategy will keep more money in your savings account and earn more interest each year.
The Bottom Line
Mental accounting
Mental accounting can affect how you view money differently based on where it came from and what it’s intended for. It is important to understand how mental accounting can affect your financial decisions, so you can stay in control of your money. By shifting your mindset, you can focus on your bottom line instead of letting emotions control your money choices.
Tips for Creating an Investment Strategy
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