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Mental Accounting Mishaps

When I was younger and got pocket money I always made sure I saved half and was allowed to spend the other half on candy and later on clothes. I learned this division of income from watching a documentary on household finance in the 1950s. I was fascinated. Income was not this absolute value. No. It was to be divided into different little jars or envelopes that served a specific purpose. A jar for rent, a jar for groceries, a jar for savings and a jar for the kids (we’re talking 1950s families here).

Although jars may have fallen out of favour, the system itself hasn’t. The distribution of income over different accounts is known as mental accounting, a concept explored by Nobel Prize winner Richard Thaler. Although mental accounting is one of the things he is now known for, he mainly outlined the pitfalls of this method (Thaler, 1999).

Mental Accounting done Wrong Mental accounting could be a great thing if it were done right. Unfortunately, it is not always done right and can lead to bad, but easily avoidable situations. One of the pitfalls of this method is the rigidness associated with it. Once people have made up their “jars”, they won’t move money in between them. For example: some people have a jar for a rainy day. It’s not really long-term savings but rather for when the washing machine breaks, or something else that is rather expensive to replace. Now, imagine a person who has had an intense month. Lots of eating out, dinner parties, you name it. As a result the “food jar” has run out before the month has. Instead of dipping into a different jar and replacing it the next month, such as the “rainy day jar”, this individual pulls out the credit card. What?!

This might seem rather dense, and it is, but it does happen. People don’t look into the money they have if it has already been distributed. Rather, they go into debt. This is of course not the way to do mental accounting. The name of the jar shouldn’t matter this much. Money is money. And you’re going to need to eat!

There is another issue with mental accounting, again caused by the credit card, and this one is related to another term Thaler has become famous for: co-holding. Co-holding means the balancing of both savings and debt, which I will outline in the next article. Thaler (1990) outlines how the credit card has led people to believe they are able to distribute more of their income over the jars. Because obviously, if your income is €5000 and you can rake up a credit card debt of €2000 per month, your total income to distribute over this month is €7000. But is it?

It works if for some reason, you have no interest on this debt and it never has to be repaid. And although I have read some articles about the amazing skills of people managing 17 interest free credit cards at the same time, this is not something the average person can, should or is willing to do.

If you are using debt to finance your current jars, your future jars will suffer as a result. Repayment needs to happen sooner or later, rather sooner because of interest rates. Do not fall into the trap of thinking credit cards enlarge your income. What goes up, must come down. Next month you will have your €5000 income minus your debt repayments to distribute over your jars. And if you couldn’t make it with €5000, how are you going to make it with even less?

Mental Accounting done Right We as human beings are fallible. We don’t understand numbers that well, let’s just be honest here. When I start talking about interest rates, minimum repayments and debt accumulation most people are either asleep or terrified. So given that we are terrible at managing our finances when it comes to mental accounting, let someone else do it. Let’s hand over everything to an app.

Now I’m not suggesting you just plug in all your information in some random app that promises to make you save €10.000 a month. That’s shady. But I have found some apps I am willing to recommend. One of those is Money Dashboard.

This article is not sponsored in any way. I do genuinely believe that it’s a great app. So what the app does is quite simple: it tells you where your money is going. If you link up all your cards and accounts, and I’m talking ALL of them, it shows you an overview of all your income, all your debt, all your savings and how all of the above are distributed. It is a great way for figuring out whether you are actually meeting your mentally accounted for targets.

I personally am a great fan of apps like these because of the fact that they are accurate. This app won’t lie to you to make you feel better about yourself. If you f-ed up, this app will show you black on white how badly you did. It’s sobering to say the least.

A second great feature is the goal setting function. You can set financial goals, such as: I want to keep groceries under €200 this month, or reduce my eating out percentage from 25% to 15% of my income. It helps. Goal setting, especially when done with a third party, increases the likelihood of you actually meeting that goal (Mento et al, 1987). After having read many meta-analyses (research looking into research done on a subject) on the topic of goal setting, I have to mention one detail: goal setting only works if the goals are realistic (Locke et al, 1981; Ordóñez et al, 2009). Otherwise, if you “overprescribe” your goal, you are even less likely to make it when having not set the goal at all and you’ll just feel terrible over it. This is a vicious cycle of demotivation.

Overall, mental accounting is a great way of splitting your income and making sure you can eat, pay rent and make it to the next month at least. However, it is best if the mental accounting is done with an app, that allows you full transparency and is able to make recommendations on the basis of the information you give it. Some of these recommendations might be to take money out of one jar to put it into a jar where your resources are quickly running out. Other recommendations might be to decrease certain categorical spending (shopping….), increase savings or start repaying debt.

For whatever you decide to use mental accounting, make sure you do it right!

References Locke, E. A., Shaw, K. N., Saari, L. M., & Latham, G. P. (1981). Goal setting and task performance: 1969–1980. Psychological bulletin, 90(1), 125.

Mento, A. J., Steel, R. P., & Karren, R. J. (1987). A meta-analytic study of the effects of goal setting on task performance: 1966–1984. Organizational behavior and human decision processes, 39(1), 52-83.

Ordóñez, L. D., Schweitzer, M. E., Galinsky, A. D., & Bazerman, M. H. (2009). Goals gone wild: The systematic side effects of overprescribing goal setting. Academy of Management Perspectives, 23(1), 6-16.

Thaler, R. H. (1990). Anomalies: Saving, fungibility, and mental accounts. Journal of economic perspectives, 4(1), 193-205.

Thaler, R. H. (1999). Mental accounting matters. Journal of Behavioral decision making, 12(3), 183-206.

Behavioural Science

Personal Finance



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