Accounting is often rather uninspiring – it’s usually about paying for things you’ve already enjoyed. Yet clever mental accounting in advance of spending can help you design a brighter financial future.
You’ve been framed
Mental accounting is when we manage many different priorities at the same time by dividing them up and “framing” or thinking of them differently. A classic 1984 behavioural economics experiment by Daniel Kahneman and Amos Tversky illustrates this really well.
Participants were asked to imagine they had bought a non-refundable $10 ticket for a play, which they then lost on entering the theatre. When asked to pay another $10 to replace this ticket, fewer than half (46%) of the people said “yes”.
What if they didn’t buy a ticket in advance, but lost $10 on the way there? Would they still buy a ticket to the play after that? When asked this, nearly nine in ten (88%) said they would.
Same but different
An equal amount was lost in both situations – but the theatre-goers thought about each $10 separately, accounting differently for the total $20. One mental “bucket” might be for purchases made – in this case, theatre tickets. In the first situation described, it would contain $20; in the other, it would only contain $10. So buying another ticket feels less costly even though the real financial loss, overall, is exactly the same.
A paper by 2017 Nobel economics prize winner Richard Thaler explains more.
There’s a hole in my bucket, dear Liza
Mental accounting is all about reducing complexity: making life easier. But it gets a bad press, partly because it means we can easily miscalculate our losses if we don’t put two items of spending in the same imaginary “bucket”.
An example can be when people “co-hold” savings and credit card debt – our ING International Survey Savings 2017 found that 28% of people in Europe admit to this. If you have credit cards and savings in two separate mental accounts, you can feel like you have more money available, even if in reality they cancel each other out.
Deliberately creating different mental "buckets" (for our money) can help us.
As a result, people who co-hold sometimes end up paying high fees to service a credit card debt – when they could easily pay it all off.
But mental accounting can help you too
Yet mental accounting’s “sleight of mind” can be a good thing if we deliberately create different mental “buckets” – perhaps even separate bank accounts – to help us. All money is fungible – a given sum of money can be used for any purpose – but earmarking specific sums for different things makes it more likely you’ll have the funds when needed.
This is partly because it’s a kind of commitment device.
One example is an emergency fund. Money set aside for emergencies will only be available to pay for unexpected events like a sudden redundancy or illness, or if your heating break downs mid-winter. Another classic example is a pension.
Deciding what you can afford
Making your goals easier to think about can help you prioritise saving for university fees, a tropical holiday, a home of your own – anything at all. Savings “buckets” can even be divided into short-term, mid-term and long-term goals.
Mental accounting can also help you create an effective budget. By dividing up and labelling the amounts you need to save and spend, it’s easier to see how far your income will stretch.
Maybe current earnings don’t quite cover all your aspirations. This might motivate you to get that extra job, or sell those items in the basement that have been gathering dust for years. Done right, mental accounting can help you make more money over time.
Your future investments
Mental accounting can help you stick to other plans too. Why not try choosing investments based on the amounts of money you need to fulfil your wish-list of individual financial goals, instead of just on the likely rate of return?
One goal might be saving for retirement. Money in that mental account might suit safer long-term investments, balancing risk against the expected number of working years. For things that are just “nice to have”, you might take more risk.
Of course classic investment principles, such as diversifying and doing your research, are still important. But you might be surprised by how quickly you can reach your financial goals if you break them down into smaller “buckets” – which you can then individually target.