The Self Deception of Mental Accounting

Consider this: the Smith household comprises two adults, John and Mary. As a couple they run their credit cards so that at the end of each month some $2,000 is left as a debit balance on which they pay 20 per cent p.a. interest. As a separate exercise, the couple prides itself on having a savings jar in which they have $1,000 as a steady balance.

It’s been this way for several years now; in the past 3 years, they have forked out $1,200 in interest to the card company. They have earned no interest on the money in the jar.

If John and Mary had used, say, $800 of their jar money to reduce their card balance in year one, they would have reduced their interest bill by 40 per cent (and still have had a couple of hundred dollars for quick access if needed).

However, they didn’t do it because of an odd behavioural tic called ‘mental accounting’. This is the practice of segmenting money into different ‘buckets’ (one for this, one for that, one for the other). It’s a behavioural trait that many people use without realising it is usually self-defeating.

If the practice was limited to a few hundred dollars of interest, so what? But it’s not. The downside of mental accounting (bucketing) can deplete a family’s investments by scores of thousands of dollars.

What’s the solution? First, should be the recognition that money is fungible – no matter where it is stored or invested, it is still money and the smarter it is allocated, the better the wealth effect. Second, overall wealth is what constitutes financial well-being, and having a bit stored here and another bit stored there is a highly inefficient way to grow and protect one’s funds.

Don’t let mental accounting limit your growth.

Key Points

Imagine bucket A contains $200, bucket B $1,800, and C contains $8,000.

Simplifying Mental Accounting

The total is $10,000, yet most people treat the buckets separately and apply different psychological values to them; for example, they happily use A to pay for everyday expenses, B for mid-term goals (holidays, etc) and C for long-term goals such as retirement. That part makes sense but what doesn’t make sense is how they might be invested. In most cases, funds in A will earn next to no yield, B a modest yield and C will earn whatever its underlying asset allocation produces.

However, the contents of B & C could be combined and invested in the same way in order to enhance overall wealth (ignore for the moment the tax benefits of C if in a superannuation fund).

If B was invested in a similar portfolio to C, it is likely that total wealth would grow far faster than when separated out.

‘Bucketing’ assets, especially where larger sums are involved is usually counter-productive.

Disclaimer & General Advice Warning

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