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Going Mental

Jonathan Clements

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:

  • Bill Ehart talked about the separate savings accounts he has for financial emergencies, a new car and his daughter’s wedding. Sure, it would be simpler and perhaps more rational to have a single savings account. But if having multiple accounts helps you to organize your finances and motivates you to save, why not go that route?
  • Howard Rohleder discussed how he paid off the mortgage just before his oldest went to college—and then took the monthly mortgage payment and redirected it to his son’s college payments. In effect, the mortgage mental account became the college mental account. Sure, there are other, potentially higher-returning college savings strategies. But this strikes me as a smart, simple way to address a major financial cost.
  • Don Southworth talked about how he and his wife divide their retirement nest egg into three financial buckets. This probably isn’t the best way to generate retirement income. But as Don notes, the bucket approach has led to “much more peace and financial serenity.” Who can argue with that?

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.

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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.

Jonathan Clements is the founder and editor of HumbleDollar. Follow him on Twitter @ClementsMoney and on Facebook, and check out his earlier articles.

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David Powell
David Powell
17 days ago

Another fan of savings buckets here, but also simplicity. We held an account per cash savings bucket for many years. Last year, I decided to consolidate to one savings account and use a balance sheet in Excel to track the amount on hand for each bucket/category. The change was prompted by a desire to simplify, and to tighten the screws on account security. It’s also easier to shift savings between discretionary categories if we change plans.

Investments are unavoidably split (taxable brokerage, rollover IRA, 401K), but in Excel it’s easy to integrate the portfolio and reason over allocations for new funds and portfolio returns while keeping more of the income-producing things in the tax-exempt accounts. I love how Excel now makes it easy to look up a fund or ETF price.

The point about motivational value of attaching purpose to a savings or investing bucket resonates. It spurred a big increase in our savings rate about a decade ago.

Last edited 17 days ago by David Powell
Bob Wilmes
Bob Wilmes
17 days ago

I wish that brokerages and banks had this bucket concept figured out. We have one bank with three accounts – checking, savings and a spending account. The spending account is only linked to a debit card my wife uses for grocery store and local purchases. Her previous debit card was involved in a hack at Target, so the spending account only has about $1000 in it and is unlinked from any other overdraft protection. If it gets hacked again we are OK. We also set the automatic alerts for text messages when we spend any amount.

I’d love the ability to split my financial accounts online into separate buckets. That way I could move the money between buckets as desired.

R Quinn
R Quinn
18 days ago

I may be the worlds biggest fan of buckets, both investments and income. My investments are 401k (counted as investment since it’s not used for retirement), a brokerage account, a couple of small rollover IRAs and two stocks, most of which were acquired as part of compensation. I view each of these for different purposes. Part of the brokerage account and the stocks can generate income if I don’t reinvest.

Several bank accounts are designated for specific purposes. One is for property taxes and other fixed expenses. Another is for travel. A couple are emergency funds and miscellaneous expenses and entertainment.

Not mixing funds gives a better picture of overall spending and finances IMO. For example, we have not traveled since April 2020, but the travel account has still accumulated and we are using it now for home remodeling. When that’s done it will be back to travel, but in the meantime we know exactly what we have to spend on the remodel and where it’s coming from. I have also temporarily suspended dividend reinvestment to add to that account which will be reversed at year end, but again in the meantime I know how much I will have and from where.

A recent unexpected dental bill was partially taken from a savings account and thus did not lower our fixed expenses account. Buckets make our financial life easier with less stress.

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