The simple answer is: Yes, we all are!In a recent blog, we looked at five financial trip-wires and glanced over the term ‘mental accounting.’
The simple answer is: Yes, we all are!
In a recent blog, we looked at five financial trip-wires and glanced over the term ‘mental accounting.’ Introduced in 1999, it’s a concept that refers to the different values we place on money. These values are often based on subjective criteria; sometimes, this subjectivity benefits us, and sometimes it doesn’t!
Mental accounting enables us to create emotional connections with our financial plan. When we consider investment strategies or risk cover, an emotional connection to the outcome, or the goal, is established and we are more likely to continue contributing money to that account.
The perceived importance of the outcome causes us to view the money involved differently. However, money is the same, no matter where we put it or how we spend it. There is a technical term for this universality of money; it’s called fungibility. Fungibility essentially speaks to the equal value of assets.
We learn about this very early in life - just think about kids in the sandpit who are learning to share. If one has the spade and bucket, and the other has the castle mould, they will very quickly figure out that swapping the mould for only the bucket, or only the spade, is not a fair value exchange. A fair trade would be both the bucket and the spade for the mould.
As we grow up and start to trade with money, we conform to the commercial conventions of our society. We exchange money for products or services, and if we pay one price for an item in one place, we expect it to be similarly priced everywhere else. If it’s more expensive, we would expect to receive more value for that item.
This is where it gets more complicated, and we learn that value is highly subjective. Something that I consider valuable may not be something that you consider valuable. Mental accounting comes into play, and we assign a different value to inherently fungible items.
In an episode of the hit series Friends, Monica discovers that Chandler (her fiance) has a large amount of money invested that could pay for her dream wedding. Chandler initially refuses to spend all that money on one event because he had other plans for the money, long-term plans that included a family and a home. After sharing these thoughts with Monica, she understands his perspective, and they make a new plan together.
According to Investopedia, mental accounting often leads people to make irrational investment decisions and behave in financially counterproductive or detrimental ways, such as funding a low-interest savings account while carrying large credit card balances.
To avoid the mental accounting bias, individuals should treat money as perfectly fungible when they allocate among different accounts, be it a budget account (everyday living expenses), a discretionary spending account, or a wealth account (savings and investments).
Mental accounting also affects our approach to long-term investing and our risk cover. When we are young, it’s harder to invest for retirement - but as we get older, this becomes a higher priority. When we are healthy and strong, it’s harder to pay for life cover or income insurance because we can’t emotionally connect to the possibility that we will need those products.
There are many other areas where mental accounting skews our perspective, like when we receive a windfall (an inheritance, a tax refund or an unexpected gift) or finish paying off a large debt. The sudden availability of money that ‘we didn’t have to work’ for seems to have a different value than the money we receive through our salary, wages or investment payouts.
It’s not easy to simply say - it’s just money. When we are emotionally engaged in our finances, we need to have the space to talk about our options (like Chandler and Monica and the kids in the sandpit) and have a third party (your financial planner) to help us find a healthy balance.
A rational approach doesn’t mean we don’t enjoy our wealth; it means we can be more intentional with our wealth. If you’re feeling a little money-mental, maybe it’s time we had a chat.
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