Are bad mental accounting habits holding you back?

Mental accounting can negatively impact your everyday financial decisions — often without you even realizing it. Learn how to recognize and overcome it.

Author: Sarita Harbour

What do you do with your tax return? Do you use it to get closer to the financial goals you already have in motion, or are you more likely to make a reservation at a pricy restaurant downtown? Your answer to this question may say less about your personality (and even your financial savvy) than about the lure of questionable reasoning habits when it comes to money.

What is mental accounting?

Developed by Nobel-winning behavioural economist Richard Thaler of the University of Chicago, mental accounting refers to a common but irrational financial decision-making process.

The concept first appeared in a 1999 article published in the Journal of Behavioral Decision Making, where Thaler defined it as "the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities."

In other words, this is what happens when, rather than seeing personal money as one overall pool of funds, people consider where their money came from as a factor in deciding how to spend it. According to Thaler's theory, this illogical reasoning leads to worse financial choices, like using your tax return on something you would never otherwise buy, at the expense of your actual financial goals.

Being able to recognize some of the common scenarios that trigger this type of financial decision-making can help you catch yourself in the act and ultimately learn how to overcome mental accounting habits that could damage your finances.

Real examples of mental accounting that might hit home

What does this look like in practice? See if any of the following scenarios sound familiar.

1. Treating windfall money differently from "earned" money

One sign of this type of reasoning is the treatment of windfall money. When you receive money unexpectedly, such as through a surprise inheritance, rebate, refund, or cash back, it's easy to misidentify these funds as gift money, or "extra" cash to have fun with. It might be easier to justify spending it on something frivolous instead of adding it to your household pool of money to pay off debt or invest.

2. Getting snagged on "sunk costs"

Have you ever overeaten at an all-you-can-eat buffet because you wanted to get your money's worth? Or sat through a concert you weren't enjoying because of the money you spent on high-priced tickets? What about continuing to wear designer shoes that pinch your feet just because you paid full price for them?

The sunk cost fallacy convinces you to continue a behaviour because you've already invested money, time, or effort into it, even though the costs of continuing on outweigh the benefit. Your mental accountant views your "sunk costs" as more important than the discomfort they cause.

3. Buying unnecessary items because they're on sale

Bargain shoppers beware! There's a fine line between the kind of bargain hunting that's financially savvy and the kind that's a drain on your wallet in disguise. 

Say you're out shopping for new jeans, when you see a sweater that's been marked down by 70% and is now $21. You buy it (plus the jeans) and congratulate yourself on saving what works out to $49. However, since you didn't need the sweater in the first place, you've actually just wasted $21. Yet the voice in your mind tells you it's a great deal.

How to overcome mental accounting bad habits

Before you can break poor financial habits, you need to recognize when you're about to repeat them. Think about the past few financial decisions you made. If any of them resemble the examples above, consider making some changes to how you think about money.

1. Create or review your budget

Don't have one? Consider an online budget tool, or even try the old-fashioned envelope method to get started. Outlining a household budget gives you a framework for where your money needs to go each month, regardless of any surprise deals you come across.

2. Anticipate the unexpected

Create and commit to a plan for irregular income such as gifts, refunds, tax returns, and end-of-year or performance bonuses. For example, instead of blowing it all on a spur-of-the-moment spending spree, try splitting your next windfall three ways. Use a third to pay off debt, put a third to savings, and then treat yourself to something fun with the rest.

3. Know your goals

At the end of the day, the trouble with mental accounting is that it creates confusion about what it is you "really" want. You know you want to be able to make a down payment on a house in five years, but a surprise new TV or phone sounds good right now. How can you say no? 

Identifying the financial priorities that really matter to you should help. While not all long-term goals are easy to get excited about (we're looking at you, paying down debt), knowing what you want — and why — can help you navigate the distractions and keep your eye on the big picture.