By Michael J. Searcy
Does the source of money you receive impact how you spend, save or invest that money? Do you treat money you earn differently than money you have won or received as a gift or bonus? If earned money feels more precious and worth saving, while the other types feel like “fun money” with which you can splurge, you may be practicing mental accounting. Beware - in mental accounting, all money is not treated as equal. You can stop mental accounting from hindering you from making the best decisions with your money, and by being aware that it’s happening, you have already made the first step.
Mental accounting is occurring when you categorize or sector your money based on subjective criteria. Your emotions or experiences cause you to treat one pot of money differently than another. I have seen mental accounting play out in many ways. One example involves a young medical professional I know who had medical school loans to pay off. He had the funds available in the form of stock his grandfather purchased for him as a young boy that was now worth several thousands of dollars. While it would have been beneficial for the young professional to use the money to pay off students loans that were costing him interest, he decided to save the money for a future down-payment on a house. He wanted to cash the stock in for something meaningful because he valued the money given by his grandfather more than money received or earned in other ways. He was willing to pay loan interest (costing him more), while letting money sit that could have been used to get him out of debt.
Another example involves a young couple who received an inheritance from the wife’s grandparents after they passed away. She felt guilty about receiving the gift and wasn’t sure how to spend the money, so she decided to park the money in CDs where it was left to earn very little interest. Because the interest earned was below the rate of inflation, the money eventually lost some of its purchasing power. Because she thought this money was different than her other savings, she was paralyzed from treating it the same and letting her money work for her in an investment account.
Treat All Money as Equal
Mental accounting can cost you. To avoid the effects of mental accounting, treat all money as equal. Money is money, and all the money you possess should be used to work toward the greatest good for your financial goals and needs. If you only budget for a specific amount per year (typically the amount you receive as salary), consider any additional increases from gifts, inheritance, winnings or bonuses as money you earned. If you treat this money as you would money you worked hard to earn, you might be less likely to splurge on unnecessary treats or to sock the money away instead of investing it alongside your other investments.
If you are interested in learning more about this topic, or other ways you can enhance your financial behavior, feel free to contact us or check out the book, “Why Smart People Make Big Money Mistakes,” by Gary Belsky and Thomas Gilovich. It might save you from mistakes hiding right under your nose.
Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this content, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for you or your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter (article) serves as the receipt of, or as a substitute for, personalized investment advice from Searcy Financial Services, Inc.
The content of this letter does not constitute a tax or legal opinion. Always consult with a competent professional service provider for advice on tax or legal matters specific to your situation. To the extent that a reader has any questions regarding the applicability of any specific issue discussed in this content, he/she is encouraged to consult with the professional advisor of his/her choosing.
Published for the blog on September 10, 2015 by Searcy Financial Services, your Overland Park, Kansas Financial Planner and Investment Manager. Originally published in Mission Hills Arts & Fashion, Summer 2013 issue.