What is the trap of mental accounting?

It sounds like the term “mental accounting” would be a wonderful thing. Who would not want to absolutely balance their checkbook in their head with utter precision? In fact, a dangerous financial trap to fall into can be mental accounting.

Mental accounting refers to the tendency of humans to develop and make decisions based on purely mental categories. Although they seem rational, the categories we create are often wholly arbitrary — and in some cases, dangerously misleading.

Although this may not sound bad, the way money is spent can cause problems. Essentially, because of biases in the way money is perceived, mental accounting contributes to irregular or illogical spending patterns.

The Free Money Fallacy is one to which I’m sure all of us can relate. Windfall or unexpected money is also only known to be “free money” and is spent more quickly than a normal paycheck. This is particularly evident during the tax season, when many of us are in a hurry to get our tax refunds, thinking about all the fun stuff that can be purchased. However the truth of the case is that this windfall income is just the same as money gained. As a matter of fact, all money is the same and should be regarded as such.

Windfall income, like the tax refund, feels easier to invest when you haven’t planned for those funds like you do with paychecks that happen daily. It is considered discovered rather than won and much easier to part with without a category allocated to the money. However that the income is unexpected does not render it any less received. Avoid the temptation to view windfalls as free cash and instead think of those large amounts as speed boosts that drive you at a blinding pace closer to your goals. How you’re asking? By making a dent in the payment of your debt or trading in the stock market.

For those who love structure or are just beginning to get their finances under control, budgeting can be a fantastic tool, but there are also some fairly significant downsides. What happens when you overestimate how much you would need to spend on a particular category because of your ineptitude to forecast the future? Well, saving and investing the difference would be the perfect answer. What usually happens, though is that for that segment, you can spend more to fill up your budget.

Consider the following example: You spend $75 on restaurant dining per month. Not my thing, but to judge you, I’m not here. With two days left in the month, all you spent was $40. Pretty good for you! Except that more than likely at least some of that gap would make you feel entitled to fill in. You decide that you should make a food run on your lunch break, despite the fact that you have plenty of food in your house and even some delicious leftovers from last night’s dinner. You grab some burgers the next day on your way home from work. You spend just another $20 between the two, always coming in well below your budget. You feel proud of undershooting the budget of your restaurant, but I’m here to pop that bubble.

Don’t get me wrong, both of these options are excellent, but what I’m questioning here is the reason for those choices. For those food runs, there was no need. You were completely capable in your home of feeding yourself with healthy food. Actually, those leftovers from dinner last night could go to waste now. That you had the “extra” budget was the only reason you felt the need to go out to eat.

This is where it will get you into trouble with mental accounting. Assigning parts of your money to different categories gives you permission to waste money on items that you don’t need. What if you had an unexpected auto repair costing you $150 when you were $35 under budget? The extra room in the budget of your restaurant should have gone towards the additional cost, but it is much more likely to fill the gap for the allocated bucket instead because of mental accounting.

This is why I suggest moving away from budgeting by type, at the very least. Budgeting establishes a daily cap on how much you can spend, allowing you the ability to spend more than you need. Instead, push yourself to see how little you need to invest to enjoy life every month. Instead, think of the minimum that you need to get by and start from there. To slowly decrease your expenditures, force yourself to make improvements.

Check out my related post: When is the best time to ask for a raise?

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