Mental Accounting and How We Spend Money
We all have quirky behaviours when it comes to managing our money. One trick we fall victim to is called mental accounting. We separate our money into different types of mental accounts, with different rules, depending upon how we get it, how we spend it, and how it makes us feel.
An easy example is when you have funds set aside for something like a vacation or house down payment while at the same time carrying high-interest credit card debt. Or how you decide to spend a $1,200 tax refund versus what you’d do with $100 per month if you had the correct amount of tax coming off your paycheque in the first place.
I’m guilty of mental accounting every month when I budget $1,000 for groceries, $200 for dining out, $125 for clothing, and $75 for alcohol. I manipulate those mental accounts all the time, like when I overspend in one category and just take it out of another (shifting a meal from ‘dining’ to ‘entertainment’ for example).
The Mental Accounting Challenge
Why do we assign money to these mental categories? One answer is to control how we think about it. If we were perfectly rational and could figure out the opportunity costs and complex trade-offs of every single financial transaction then it wouldn’t matter how we label our money – it would just come from a big pool called ‘our money.’ It’s just money, after all; totally fungible and interchangeable.
But because we’re human with cognitive limitations and emotions we need help with our money decisions. That’s where mental accounting comes in and acts as a useful shortcut for what decisions to make.
Another interesting way we classify our financial decisions has to do with the length of time between when we bought an item and when we consumed it.
Nobel Prize winner Richard Thaler studied wine purchases and consumption and found that advance purchases of wine are often thought of as investments. Months or years later, when the bottle is opened and consumed, the consumption feels free, as if no money was spent on wine that evening.
Think of a couple that prepays an all-inclusive holiday to the Dominican versus a couple who books their flight and hotel, but opts for a-la-carte dining and entertainment options. The all-inclusive couple probably paid more for their trip, but since it was prepaid and all of their drinks, food, snorkelling and surfing is included, they likely had a more enjoyable experience than the couple who saved money on flight and hotel, but then had to pay as they go for everything else – feeling the pain of every purchase in the moment.
In the personal finance world, one common way to try and save money is with a ‘no-spend’ challenge for a day, week, or month. The idea is pretty straightforward – try not to spend any money. What we’re really doing is playing a mental trick on ourselves.
It’s damn near impossible to go a day without spending if you think about your money as one big pool of interchangeable dollars. Let’s say your rent is $1,200 and it comes out on the 1st of the month. Does that mean you don’t spend any money on rent from the 2nd to the 30th? Or is it that rent actually costs $40 per day and you simply prepay it at the beginning of every month?
The same can be said for insurance, groceries, gas, electricity, the list goes on. It’s easy to game a no-spend challenge the day after your fridge was filled and your bills were paid.
Indeed, when we talk about a no-spend day what we really mean is we’re not going to violate or manipulate our spending rules today.
Final thoughts
Behavioural economist Dan Ariely says mental accounting is perfectly normal. We’re real people after all, with emotions and stress and annoyance and deadlines and a lot of other things to do.
If we have to think about the pros and cons of our decisions every time we want to buy a specific item such as coffee, gas, an app, or a sandwich, it’s going to be a huge pain in the butt. The creation of complex budget categories often gets people to stop budgeting altogether.
Instead, if you have a hard time controlling your spending, Ariely suggests you decide how much you want to spend on a broad category of ‘discretionary items’ – things you can live without, like special brew coffee, fancy shoes, or a night of drinking.
Take that amount, on a weekly basis, and put it on a prepaid debit card. The opportunity cost of your decisions in this general category will be more apparent and more immediate. It still requires effort, but it’s not as annoying as separate accounts for coffee, beer, and Uber.
According to Ariely, this is one way we can use mental accounting in our favour while recognizing the complexity and pressures of our real lives.
Do you use mental accounting to help manage your money?
I see some forms of mental accounting as a rational response to the fact that the time and effort we put into making decisions has a cost. So, if we’re trying to be rational and account for all relevant costs when making decisions, we have to limit the time we spend making decisions. This necessarily means using easy rules of thumb (or mental accounting rules) that we only examine infrequently.
Agreed, Michael. I find this is one of the rare examples of behavioural finance that points to a thing we do and justifies it (mostly) as useful.
But at the same time I speak with many clients who have strange mental accounting rules for certain types of income (take my RRIF minimum and put it in my TFSA, for example, when the TFSA contribution could come from any number of sources).
I find it helpful to treat retirement income as fungible, especially since we’ll often have many different income streams (pension, CPP, OAS, RRIF, TFSA, non-registered). That way, I won’t need to think about using a pension to pay my mortgage (if I still had one). Instead, the sources of income will flow into my chequing account, pay my bills, and then I can spend the rest guilt-free.
Budgeting $75/mo for alcohol. I guess the rest that you spend on alcohol is “entertainment”;)
I am curious whether you extend your pragmatic/fungible thinking to Emergency Funds?
Hi Bob, yes exactly – fungible!
Good question about emergency funds. I would say no, these funds aren’t part of the fungible bucket. Not that I wouldn’t “loan” myself money from my EF if for some reason I didn’t have cash on hand for regular, non emergency living. But I find it’s a slippery slope to dip into emergency savings that way on a regular basis.
You put the quarter in on that question! For reference, I’m a bookkeeper. I helped people track and record their finances. Mental accounting is very dangerous because we always mentally make any purchase decision in the “justified” category. Budgets really do nothing IMO because once you overspend in one category you “steal” from another mentally but then conveniently forget when you use up that allocation as well!
Cash is the worst. Money spent with the idea of tracking but next thing you know it’s all gone and you have no idea where it went. Only way to go IMO is to record monthly what you spend with an annual budget figure in mind. Adjustments can be made as you go as long as you accurately and honestly record spending. It took me about 6 months into early retirement before I buckled down and did what needed to be done. Now I take about an hour month to record all transactions and now have 10 years of data to pull from for whatever financial decisions need to be made. But that’s just me I guess!
Good way of putting it. I record every purchase we make into a category (not too many) that I have pre-filled with a monthly amount. We are near retirement and need to know what we are spending. I have a records for a few years and look back all the time. The fact that you are a book keeper makes me feel that I am on the right track. Just to put it out there…my LCBO purchases are more than $75 a month. Cheers
When we took the leap into retirement it was a bit of a leap of faith. I hadn’t done the pre-work to definitely know how much we needed, but our planning and saving worked in our favour. I had polled many retired friends to find out how they managed their money and how much their lifestyle cost. Nobody could give me a clear answer. Even financial advisors are more informed on saving than spending. If anyone asks me for advice, that’s my #1 answer. It doesn’t have to be in depth, I have categories of “Costco” and “Walmart” cuz I don’t want to break everything down but at least I understand where I spent the money. As for $75/mo on LCBO, you’re obviously an amateur! Ha ha! Part of the process is acknowledging your spending priorities. Some spend thousands on travel, others enjoy beer in the backyard (in quantity ) As long as you’ve got food and shelter, the extras are whatever works for you.
I am tracking my expenses now and looking at it at more of a “month to month” basis. Some months I eat out more, some I buy more presents. As long as at the end of the month I hit my budget I am ok with that.
A friend of mine was given a budget by her financial advisor when they retired (based on her numbers of course). One of the items was $100/month for auto repair (example #s used) which she figured was totally reasonable. 3rd month in, she had a $500 repair bill so she was devastated she broke her budget. That’s why annual budgets with monthly checks and corrective action bodes well for success. Good habit to be into so that’s half the battle!
I had read about Ariely’s suggestion about just having a discretionary fund category, but my concern is i may spend the money on what happens to be first and not have anything over for other categories. I track my money but perhaps whats most important as someone said is that you didn’t go over budget and it is interesting to see how you spent.