AS I DRIVE AROUND town these days, I notice a lot of cars with temporary license plates—an indication they were recently purchased. What’s the reason? When I turn on the TV, I see a commercial for a local car dealership that’s offering to accept your tax refund as the down payment on a new car. Now it starts to make sense.
The dealership knows consumers are about to receive an influx of cash. It wants to make it as painless as possible to buy a new car. Meanwhile, you—the consumer—view your tax refund as a windfall, making it seem like a painless way to purchase the car you’ve been eyeing for the past few months. I’ve seen furniture stores use the same strategy.
This type of financial behavior is known as mental accounting. Nobel Laureate Richard Thaler defined it as “the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities.” In other words, mental accounting refers to how you assign funds to different categories, often based on the money’s origin. The easiest example: People spend the money in their wallet differently from, say, the money in their savings account.
We use mental accounting throughout our daily lives. There’s nothing wrong with that. In fact, it can help you make better financial decisions—and avoid big mistakes. Here are three ways I use mental accounting:
1. Reinvesting dividends. Rationally, I should view the dividends I receive from my investments in the same way I view my earned income. But I don’t and, indeed, I don’t give myself the option to spend those dividends. Instead, I reinvest them automatically, so I am purchasing shares throughout the year without any effort. This small step will help increase my wealth over time.
2. Deploying windfalls. Individuals will typically use a windfall to purchase luxury goods—like the cars I’ve recently seen around town. I’m not going to claim that I’ve never spent a windfall on a luxury good that I normally wouldn’t buy. I am human, after all.
Still, I try to take a thoughtful approach to the windfalls I receive. My favorite strategy is to break them up like this: 25% to my emergency fund, 25% to my investment account, 25% toward a fun luxury and 25% to charity. With this approach, I buy a little happiness—but also bolster my net worth.
3. Bucketing money. My earned income goes directly into my checking account every month. In the days immediately after, I have automatic transfers set up to accomplish several goals, including paying off my credit card in full, setting aside money for self-employment taxes, contributing to my Roth IRA and growing my emergency fund.
Each of these financial accounts is also a mental account. They help me keep my finances organized—and keep me focused on my goals.
Ross Menke is a Certified Financial Planner. He’s passionate about helping folks make financial decisions that reflect their true purpose. Ross’s previous articles include Full Speed Ahead, Up to You and No Money Down. Follow Ross on Twitter @RossVMenke.