Don’t miss the big picture

TAKING ACCOUNT OF MENTAL ACCOUNTING

Mental accounting is the tendency we sometimes have to treat the same thing – money, in particular – differently depending on where it came from or what we intend to do with it.

Consider this scenario: You buy a movie ticket in advance, but when you arrive at the theater, it’s nowhere to be found. What if it were the cash in your pocket that had gone missing? Would you be inclined to spend additional money to replace the ticket or to “replace” the lost cash?

A study that posited exactly this situation found that just 46% of respondents would spend additional money to replace a lost movie ticket – since they’d already spent the money they’d mentally accounted for that purpose – but 88% would spend again if it were cash they lost.¹ Even though the two scenarios are effectively identical, our brains tend to treat them in completely different ways.

70% of winners of lottery windfalls end up bankrupt, and the more they receive, the likelier they are to go broke. Source: CNBC, Don’t fumble a financial windfall: Plan a strategy

Mental accounting can lead people to:

• Focus on individual account performance rather than their overall portfolio
• Hold fast to certain principles (eg. I must open a savings account for my child; I must pay off all debt as quickly as possible.)
• Feel most comfortable holding cash or low-risk securities
• Think of a holiday bonus or tax refund differently than a regular paycheck

IS MENTAL ACCOUNTING GIVING YOU TUNNEL VISION?

Mental accounting hinges on the idea that all money is interchange- able, but we frequently fail to treat it that way, leading us to sort our assets into distinct “accounts” both figuratively and literally.

For example, the tendency to treat windfalls differently is one of the greatest threats mental accounting can pose to your finances. You see it in the incredible rates at which lottery winners end up bankrupt or how 80% of NFL players have depleted their mammoth fortunes within just three years of retiring from the competitive field.²

But mental accounting also operates on a smaller scale, leading people to do things like spend an unexpected inheritance on a luxury purchase instead of saving it like they would other income. Or to shortchange their long-term goals because they’re too focused on the short-term performance of one particular “bucket.”

33% of people – and 50% of millennials – plan to use their tax refunds to pay for travel. Source: Detroit Free Press

When mental accounting factors into your financial plan:

• You might undercut your financial progress by treating certain inflows (bonuses, tax refunds) as more “spendable” than others (like your regular paycheck)..
• You’re so focused on certain goals, like funding a child’s college tuition, that you neglect long-term ones, like retirement.
• You might lock in losses if you’re saving money in low-risk vehicles but paying a higher interest rate on any form of debt.
• You might miss out on gains if you’re paying off low-rate debt faster than necessary when you could receive a better return by investing that money.
• You might trigger the wash sale rule (which applies across your accounts as well as your spouse’s) if you sell a security for the tax benefit in one account but unwittingly repurchase a substantially identical security in another.

THE GUARDRAIL

Mental accounting is one of the surest ways to keep a financial plan from reaching its full potential. While it’s important to pay attention to the little things, remember that sometimes the most important step toward achieving your long-term financial goals is taking a step back. Leverage tools from your financial institutions that provide a comprehensive view of your various accounts and can help you better clarify your financial needs and goals.

Just as important is ensuring you have a reliable source of objective information and guidance. Seek out the perspectives of people whose beliefs differ from your own and professionals with specialized expertise. As your financial advisor, I can serve as an unbiased third party, offering the perspective you need as well as comprehensive financial planning guidance to help you move toward your future with confidence.

THINK BEFORE YOU ACT

To help you keep mental accounting from derailing your financial plan:

• Treat money with the same careful consideration no matter where it comes from or how you plan to use it.
• Don’t interrupt your financial progress by changing spending habits based on circumstance, whether you’re on vacation or experience a good day in the market.
• Talk with your children and heirs about what it took to build your wealth and what your wishes are for its future, so when the time comes to pass it down, they don’t see it as a “lottery win” and misspend.

¹Psychology Today, Mental accounting and self control
²Forbes