Is a dollar always a dollar? The easy answer, of course, is yes. A dollar in your wallet is the same as a dollar in a piggy bank, which is the same as a dollar invested in the stock market. It’s simple logic, right?
Unfortunately, humans are rarely logical beings when it comes to our finances. We routinely place different values on the exact same amount of money. This is known as “mental accounting.” It is the practice of mentally sorting our funds into different buckets, based on subjective perceptions of value.
Being aware of how mental accounting works can help you make more informed financial decisions.
Many everyday activities are influenced by our mental accounting. Take an example I was guilty of recently. I returned an online shopping order and received a credit. I figured this was money “already spent.” So what did I do? Instead of saving the credit or using it to buy something I actually needed, I bought something frivolous.
How about credit card points? Many of us use credit cards for daily transactions. These purchases can accrue cash back, or points. As long as the credit card balance is paid off monthly, these points are an additional source of income. A dollar in rewards is the same as a dollar in salary. In fact, points might actually be better; credit card points are tax-free. But when is the last time you used credit card points to pay your mortgage? The points were probably used for a vacation, or a set of golf clubs. Why is that?
How about the money that you just received in a holiday card? It seems easier to spend that $20 than to spend $20 that you had in your savings account. This is the power mental accounting holds over our decision making.
One of the ways we see mental accounting in our profession is when it comes to tax returns. Many people see their return as a bonus; in reality, it is only the IRS paying you back money you should have kept in your pocket. A $5,000 tax return at the end of the year, while a nice in-flow to your bank account, is really a return of capital that could have been used for other things over the course of the past year. That money could have paid off interest-bearing loans, been invested for the long-term, or even increased your everyday standard of living. Instead, because tax returns are often mentally accounted for as a cash bonus, many times they are spent frivolously or, worse, planned for as a type of forced savings (without the benefit of interest earned).
Mental accounting also comes into play in investing. Many investors have a “safe number” that they want to see in their account balance. Once the account climbs above this number, they think the additional dollars can be used for speculating. If the balance goes up, great! If those speculative dollars disappear, “Oh well.” They still have their “number.” This is clearly not the way to build a well-diversified portfolio. Broadly diversifying asset classes and treating all money as one coherent portfolio is a more sound strategy.
Similarly, if the account balance goes below their magic number, mental accounting investors look to sell everything and hold cash until funds can be added to reach their safety zone. By selling at a loss, this can lead to a mistake that investors may never recover from.
Resist the mental accounting urge. A well-constructed portfolio is built to withstand market fluctuations over the long term.
It is important to recognize mental accounting when it happens. If you find yourself sorting money into different buckets with subjective thresholds, it might be time to revisit your personal financial goals. Mental accounting can negatively impact even the best financial plans if you are not diligent. A beneficial way to stay on track is to review your budget, sources of income, and financial accounts on a routine schedule.
If you find yourself using mental accounting, or feel overwhelmed by personal finance decisions, a professional can help. Constructing a sound financial plan, and understanding human behaviors are two ways to develop a successful relationship with your money. Just remember – $1 is always $1, no matter where you put it, or where it came from.
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