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How Mental Accounting Can Help or Hurt Us

Last fall, I read Why Smart People Make Big Money Mistakes and How to Correct Them: The Science of Behavioral Economics by Gary Belsky and Thomas Gilovich. This is a summary of one of the most important takeaways (though there’s lots of good stuff!), from the first chapter “Not All Dollars are Created Equal.”

Belsky and Gilovich write that a lot of our misuse or waste of money is because we have emotional mental accounting systems (as compared to running the numbers in a spreadsheet). In our mental accounting, we tend to treat money as if it’s not equal. For example, we often feel more willing to spend “found money”–a gift or money that we somehow acquired without work on our part. On the other hand, we (hopefully) treat college funds as if they’re sacred.

The authors see mental accounting as both a potential pitfall and a useful tool.

US dollars all have the same buying power. If you wouldn’t take $50 from your savings account for this purchase, why do you spend your $50 of tax return money on it? (The authors point out, too, that tax returns are actually money you earned…like having a loan returned by a friend who didn’t pay interest.)

Their solutions? I’ll list them in order of my favorites, instead of using the book’s order.

  • Imagine that all income is earned income — Their key point, I think. Don’t treat money as if it’s unimportant because it was a gift or windfall. It’s still worth the same. Sure, you can use it to do something fun, but make sure you’re not just throwing it away.
  • Use mental accounting to your advantage — Don’t touch your IRA/401(k). Put your savings on automatic so that it doesn’t feel like you have as much money coming in. That way you’ll be less likely to find a place to spend it.
  • Hurry up and wait — If you get windfall money, wait on using it. 3-6 months if possible. Put it in your savings and see it make itself at home there. You probably won’t want to pull it out again, unless the purchase is really important to you.
  • See the trees for the forest — Don’t let lots of small charges build up into an amount so big that you don’t see it as charges any more. Otherwise you’ll be less hesitant to add to it.
  • Imagine a world without plastic — figure out what you’d be willing to pay/buy if you didn’t put it on your credit card. You can still charge it, they say, but be aware that this is real money, don’t stick it in the “big amount of money I’m going to pay off someday” file.

If you’re meeting your budget, then I see nothing wrong with using unexpected money for fun. But sometimes that money creates a mentality that leads us to spend a lot more, unless we take care of it the same way we would with the rest of our budget. And extra $100 may lead us to spend $200…all in little bits and all while thinking “Oh, well I have an extra $100 this month!”

But if we budget the found-money on its own or at least keep a tally of what we’ve spent it on, there’s nothing wrong with using it for fun. You just have to decide if this type of fun is consistent with your own budget and goals.

{ 5 comments… read them below or add one }

Jesse August 6, 2008 at 12:30 pm

This is a big issue for me: if I see the money in my account is much harder to regulate and stick to budget….and the same goes for windfall money, if its not put away it feels like “free” or “extra” money.

My Daily Dollars August 7, 2008 at 11:32 am

I have SO fallen into the trap of overspending extra money. I really like the idea of socking it away in savings for a few months. I’ve been known to spend it three times over a few months BEFORE I even get the actual money. Great tip!

Marc and Angel Hack Life August 7, 2008 at 9:01 pm

Great topic. The key for me is automatic deposits (including 50% of bonuses) in a money maket account… they eliminate the temptation.

Marc and Angel Hack Life August 7, 2008 at 9:04 pm

…also, Stumbled for ya. 😉

ChristianPF August 8, 2008 at 10:07 am

I think this is just another reason why budgeting is necessary to keep spending under control…

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