You would have heard everyone suggesting you write down your plans on paper and keep emotions aside while executing them, especially in personal finance.
This is because we humans are irrational. We are filled with so many biases that it’s hard to take an action without being biased. And these biases can cost you a lot in personal finance.
Being bias-free sounds impossible, but being aware of them can help you avoid them to some extent. And for this, we are starting a new personal finance bias series to discuss various biases affecting your personal finance.
And we would like to start the series with mental accounting bias.
Estimated read time: 3 minutes and 48 seconds
Buckle up, here we go!
What is Mental Accounting Bias?
Termed by economist Richard H. Thaler, mental accounting bias is a way of thinking about money that can negatively affect your financial decision-making.
It happens when we categorise money differently based on its source or intended use, rather than treating it as a single, replaceable object.
For example, let’s say you received your salary today. You might decide to put your salary after fixed expenses into your savings account because you feel that money is “serious” and should be saved.
However, when you receive a cash gift from your grandparents, how do you spend it? You might view the gift as “extra” money and decide to spend it on a night out with friends or a new outfit.
This is an example of mental accounting bias because you are treating money from salary and gift differently, even though it is all just money that you can use to meet your financial goals.
By treating the gift as “extra” money that can be spent right away, you may miss out on the opportunity to put it towards your long-term savings goals or invest it.
This type of categorisation leads to suboptimal decision-making, as you may make different choices with the same amount of money based on how you mentally categorise it.
But wait? With this example, we don’t want you to become all serious about the money and allocate everything towards your financial goals.
We want you to recognise mental accounting bias and make an effort to view all money as fungible so that you can make the most of your financial resources.
Because mental accounting bias can lead you to spend more freely in certain areas of your life while being overly restrictive in others. This can also cost you to pass up on potential opportunities for investment or savings that would benefit you in the long run.
Being aware of this bias can help you avoid being impulsive, with unexpected money received because you did not factor such income into your financial plan.
How to avoid mental accounting bias?
Economist Richard H. Thaler advised we should treat all money the same and spend the unexpected money we received the same way we would spend our regular income based on our solid financial plan.
The best thing you can do to avoid mental accounting bias is to be deliberate with your money: think critically about your spending habits and honestly ask yourself if there is any room for improvement.
Before spending the money, take 2 mins and ask yourself whether this is the right decision? Are you biased now? Or you can delay your spending for 1 week. This will help you avoid making impulsive decisions.
Most importantly, create a budget. Instead of just keeping mental tabs on how you will spend your money, it’s helpful to make an outline of all your expenses and how much you would ideally spend in each category.
We have written about some budgeting methods here.
Also, make a plan for unexpected income. We often end up spending gift or bonus money on spur-of-the-moment purchases. Instead, you can plan ahead, like deciding to put half of the unexpected money into a savings account and spending half on a treat of some kind.
Can mental accounting be used to your advantage?
Although we rarely recognise mental accounting since it happens subconsciously, it happens all the time.
And sometimes mental accounting is helpful. Perhaps you have an account dedicated to an emergency fund that you won’t touch for anything else. Or maybe you mentally reserve a portion of your investments for your children’s education. No harm there.
Mental accounting is our mental way of saying, “This money is for this, and that money is for that.”
We must wisely use mental accounting to gain financial flexibility and align our financial goals appropriately.
While it can work to our benefit, mental accounting can also work against us. When we create these accounts of money in our heads, we can use those accounts to justify choices that aren’t ideal.
We must watch out if we are overly tied to our mental accounts. Sometimes saving or spending from a particular mental account makes better financial sense.
If we don’t recognise how we’re thinking or if we are too tied to our mental accounts, it can lead to costlier choices that leave us worse off overall.
Rather than piece by piece, the best financial decisions are made holistically and focus on reducing overall expenses, increasing total returns and peace of mind.
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