Money Traps, Part 4: Mental Accounting

by Jessica Sommerfield · 1 comment

Whenever I receive an unexpected lump of cash such as a gift card, bonus, or tax refund, I find myself extremely tempted to treat it differently than other income. Instead of looking at the budget to see where it might best benefit our overall financial situation, I immediately think of what “extra” thing I could spend it on since, well, it’s “extra” income, right? The bills will still get paid and the budget won’t suffer, regardless of what I do with the money.

I’m not alone in this mentality. Apparently, it’s something financial behavioral psychologists call mental accounting. Basically, this means we tend to assign different values to different money sources based on how much effort we put into earning them. Income that’s gifted doesn’t seem like our money, somehow, so we treat it differently, whether more cautiously or more frivolously.

The first tendency, as I started with, is the impulse to spend it. It’s easier to treat extra money with less discretion than we do our hard-earned payroll check. A 2009 study done by Harvard researchers illustrates this point. Participants in one study group were given $10 more per person than those in the other group and told this was “extra” money; consequently, they spent 20% more than the other group.

Although there’s nothing wrong with spending a little of your bonus or settlement money on something you want, extra money can tempt you to make poor decisions, especially when the amount is significant. For instance, you might rationalize using an extra lump of money for a down payment on a fancy car you otherwise wouldn’t be able to afford. This adds a monthly payment and thereby affects your budget, and, sometimes, even your lifestyle expectations.

This is the first way we tend to treat extra money, but there’s another scenario: treating certain sources of income as “sacred.” It might be inheritance money, a gift from a relative, or retirement funds you’ve saved up. Some people are afraid to use “sacred” funds for normal budget purposes or slightly riskier investments, so this money is guarded in safer places. The downfall of this behavior is missing out on maximizing your earning potential with higher-yielding investments. Less risky stocks or basic savings accounts may protect this extra money, but it won’t necessarily grow.

David’s Note: Although this is slightly different than receiving a lump sum, I have a separate pot of money I treat differently too. Most of my investments are in widely diversified index funds, but there’s a smaller pot at another brokerage firm that has individual stocks. I bought these with money I took out in a very low cost loan a few years ago, and I rationalize that it’s smart as long as the return on these individual stocks are higher than the cost of servicing the loan. Never mind that my overall investment portfolio is way ahead in terms of performance, and never mind that the index fund approach also carries lower risk, because, hey, I’m still ahead with the individual stocks right? Now that I think about the situation, not only did I make a mistake when I purchase those stocks by not treating every dollar the same, but I’m still showing a lack of judgement now by not selling the stocks and purchasing the index funds. There are capital gains to be concerned about, but the magnitude of the problem will only grow worst as investment values increase over time.

So, what’s the solution to these two pitfalls of mental accounting? The key is to change the way you think about income, whether earned or gifted. Think of all the money you receive as your money, and all your money as equal. Regardless of where it comes from, all money is the same, so use it like you would if it all came from the same source.

In a practical sense, this means looking at your debt, your budget, your retirement plans, and your savings categories and deciding where “extra money” income will best serve your overall financial health. This might mean paying off some high-interest debt, increasing your retirement savings, or investing in a higher-yielding fund or savings goal.

Don’t let mental accounting lead you to treat extra money any differently than the income that it is. Use it wisely and you’ll yield financial rewards that keep on giving.

Like this article? Check out the other parts of the money trap series below:

Money Saving Tip: An incredibly effective way to save more is to reduce your monthly Internet and TV costs. Click here for the current AT&T DSL and U-VERSE promotion codes and promos and see if you can save more money every month from now on.

{ read the comments below or add one }

  • Stephen says:

    Good advice. I myself do it and since I opened a mint account I can better track it and not do any mental accounting, well… I do but not implement.
    I’m just too afraid to put a big lump in the index funds now that it has gone up so much. Keeping all in cash until P/E comes down a bit. I know lots of people don’t like that but that is just me

Cancel reply

Leave a Comment