WE ALL TEND TO VIEW our money as a series of distinct financial buckets. Economists consider such “mental accounting” to be irrational, and perhaps it is. But it’s also mighty useful. Consider some recent articles from HumbleDollar’s writers:
To be sure, mental accounting also has its drawbacks. In an article last week, John Lim noted that we tend to view each investment we own as a separate mental account, and then fret about whether that mental account is showing a gain or loss. One consequence: Even if we own diversified portfolios, we may not get the full emotional benefit because we focus less on our portfolio’s overall value and more on the fate of each individual investment.
Another drawback of mental accounting: We may start reaching for yield. Many of us are loath to sell investments to generate income, but we’re more than happy to spend the interest and dividends we receive. It’s the old “never spend principal” rule. The danger: If we allow ourselves only to spend income, we may load up on high-yielding stocks and bonds—and end up banking on a fistful of shaky companies.
An additional pitfall: We may miss opportunities because we fail to look at our finances holistically. For instance, if we think of our mortgage as part of our house mental account, we may not compare the interest rate we’re paying to the yield on our portfolio’s bonds and cash investments. Result: We miss the chance to bolster our overall financial return by selling bonds and cash, and then using the proceeds to pay down our mortgage.
Still, I think mental accounting is far more likely to help than hurt—for four reasons.
First, it can allow us to better organize our finances. By having money earmarked for our various goals, we have a clearer idea of why we’re investing—and that can help ensure we take the right amount of risk with each mental account.
Second, it can increase motivation. Because we’ve attached goals to each pool of money, we’ll be more enthused about seeing each mental account grow, and that may motivate us to save even more each month.
Third, it can help us to control spending. For instance, many of us feel free to spend money that’s in our checking account. But if we move some of this cash into, say, a savings account or a mutual fund, we won’t just boost our potential returns. By doing so, we place these dollars into mental accounts that many of us deem untouchable—which means we’re unlikely to spend this money unless it’s a dire financial emergency.
Similarly, many of us distinguish between regular income and windfalls. We’re happy to spend our regular paycheck. But we’re much more careful with money that arrives infrequently, such as year-end bonuses, tax refunds or money from moonlighting. The upshot: These windfalls are far more likely to be saved for longer-term goals.
Finally, mental accounting can help us stay calm when markets go wild. If we track our overall portfolio’s value but don’t bother looking at the component parts, a big down day in the stock market can be unnerving because our total portfolio’s value will almost certainly decline. But if we mentally separate our portfolio into risky growth investments and stable, safe money, we may find it easier to sleep at night.
Sure, our stocks and stock funds might have taken a beating, and those losses may be hard to stomach. But we can also look at our safe money and think about the safety net we have—one that could allow us to ride out a long bear market without having to sell stocks at fire-sale prices.