All money is still only money, but savers and investors easily fall prey to the fallacy of creating mental categories for dealing with their assets. This may depend on how the investor earned their money or if they feel an emotionally attachment to their dollars. Click through to learn about a more rational way of thinking about money.
There are some justifications for using imaginary symbols for money. In particular, these symbols work as a shortcut, saving time and effort. Yet they also can operate as a trap, leading to counterproductive investment strategies. For example, if you find a twenty dollar note on the sidewalk, would you treat it as a kind of gratuity from the gods? Would you spend it with abandon or on an impulsive purchase? Most people tend to view unexpected cash inflows differently from regular income. Consider the following:
- Tax refunds – you may be expecting one, but you rarely know the precise amount
- Birthday gift money
- Bonuses – they feel a bit like grown up birthday money
- Lottery or game winnings – note that many winners shortly go bankrupt after a spending binge
- Speculative investment accounts versus safety capital – “mad” money may seem to invite risky behavior
Why should we treat unexpected gains so irrationally? Part of the reason is that people do not regard them in absolute financial terms, but instead, regard them to other circumstances. For one thing, they prefer to separate gains and losses into distinct buckets, so they can deal with the arithmetic all at once. Psychologically, investors find it easier to deal with the losses together, rather than as spaced out at intervals – which is why credit card disbursements seem more manageable. Moreover, advance purchases on items to be consumed later in the future seem smaller.
The mind plays another trick via “transactional utility”: the perceived value of getting a good deal. The concept was developed by Professor Richard Thaler, who explored the wider topics in in this1999 book Mental Accounting Matters. Every investor knows the joy of buying a stock more cheaply today than yesterday. Consumers love finding bargains, the difference between the price they expect and the actual price they pay. Similarly, they are willing to pay a premium for snacks at sporting events or at movie theaters because their definition of a reasonable price depends on the situation.
Method in the madness
There are valid reasons for compartmentalizing expenditures into mental jars. It may help control the temptation to irresponsible spending. It may lead you to minimize your consumer debt. Or, when your funds are limited, it may aid in compromising between competing uses.
Yet there are plenty of risks from creating false labels, too. When investors do not view all their assets together, they may be reluctant to move funds between accounts. For example, carrying credit card debt is illogical, but people stubbornly cling to it. They should theoretically be treating their everyday living expenses, their discretionary spending on luxury items, their savings and their investments all the same.
Nor do consumers evaluate purchase prices sensibly. If they have already in their minds earmarked funds toward a purchase, they are inclined to disregard changing conditions, and not respond to them thoughtfully. It is well accepted they can easily succumb to skillful marketing tactics. They might spend money on indulgent treats and luxury goods, just to accommodate their fanciest mental jar. They easily forget that all spending should be weighed up against the alternatives. Do you really want to pay for a single-night hotel upgrade, rather than a new winter coat?
Resisting the distortions
Investors and consumers can follow some basic guidelines to avoid the traps of mental accounting. You can train yourself to think more rationally about your money and spending patterns.
Start with a written budget so you know realistically where the funds are going. You might create a special category for windfalls. If you are going to spend it as fun money, do so deliberately and with awareness.
Above all, make sure to track your own investments holistically. Your financial advisor can help you organize your accounts in one place, so you can see and approach them more clearly.