The trap of mental accounting (give every dollar a job)
$1 always equals $1…right?! Not so fast…
👋 Welcome to the latest issue of How To Money by Kate Campbell – the newsletter that talks about all those money things you wish you had learnt in high school.
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Dear Reader,
Over the past few years, I've been exploring the ‘why’ behind our financial decisions because they’re never quite as clear-cut as they appear on the surface. So many mental traps can catch us out on our money journey that it’s only right to start tackling them in more detail.
Something that I like to remind myself is that perfect conditions for our financial decisions don’t exist. If we look for one, there will always be a reason not to pay off debt, save, or invest. And if we know there will never be a right or perfect time to do anything, it takes a lot of pressure off our shoulders to make sure we have everything lined up before we make a decision.
Today, I want to discuss the idea of mental accounting.
What is mental accounting?
$1 always equals $1…right?! Not so fast…
There’s this concept called mental accounting, which basically means there’s a lot more to each $1 than meets the eye. Depending on where the $1 came from and where it’s going, it can sometimes feel like 50 cents or $1.50.
Have you ever received a gift card and realised how much easier it is to spend that money at the store than if you were paying for it directly?
I personally find it difficult to spend money on a massage, but it’s a whole different experience if I receive a gift card, or gift a voucher to my friends. Weird how that works…
Assigning different values to the various parts of our financial life is a very human trait.
We give money rules and assign it a value in our minds based on:
🎁 Where we got the money from (e.g. 9-5 paycheque, tax refund or gift)
🚀 Where the money is going (e.g. health insurance, a trip to QLD or repairing a broken tap)
😌 How we feel about the situation (a planned repair vs an unexpected one)
💎 Our personal values (what we value spending money on)
It’s important to understand how we frame the situation in which we receive and spend money because sometimes we might realise we’re spending the money we receive unexpectedly in a way that doesn’t align with our financial goals.
Mental accounting can cause us to spend illogically and extravagantly because it alters our perception of the value of the money we receive and spend.
Example: You get a $1,000 tax refund
Did the ATO tell you $1,000 was heading your way after you dutifully rallied your receipts and submitted your tax return this year? Boom!
At this point, you might be daydreaming about all the ways you could spend that money…fancy sneakers, a Summer getaway, concert tickets…things that you might have had no intention of buying 10 minutes ago.
Let me give you three different realities of how this situation could go when the money hits your account:
Reality #1: You spend every last cent on things that you may or may not have wanted to buy earlier in the month because it’s free money…right?
Reality #2: You don’t directly spend the money; it just goes into your daily spending account, and after a few months, it slowly disappears through general expenses without you really thinking about it.
Reality #3: You realise that this is money you worked hard for and should be treated like it has value (respect the dollar, mate).
So, you look at how you’re tracking towards your money goals for the year and jot down a quick plan in your notes app: $500 to your investing account, $300 into your holiday savings account, and $200 to spend on a night out with friends.
In 12-months, you check back in with that note and feel happy that you balanced current you and future you and spent that money with intention.
Breaking free of mental accounting
It all comes down to spending your money with intention. If you check in with your money goals when you receive an unexpected sum of money, you can make sure it’s allocated in a way that makes both present and future you proud.
Whether that’s putting money into your super or spending it on a new computer (maybe even both), don’t let the trap of mental accounting warp your perception of the money you receive.
🤔 What’s the next best step you can take with your money?
My tip: Make a plan for unexpected income like tax refunds, bonuses and gifts! Don’t let the money fall into general revenue or get spent on something that doesn’t align with your goals and values. Create a note of your phone and quickly jot down how you’re allocating that money.
Have you ever received an unexpected windfall? How did you spend, save or invest it? Let me know in the comments below ⬇️
All the best for your financial future,
Kate
Thanks for reading
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