Do Not Miss the Big Picture

Mental accounting is a bias that can keep you so focused on the individual trees that you miss the forest. It is why people treat an annual bonus differently than the rest of their income, or why a business owner might view profit from a great quarter as different money than the steady draw they take each month. For business owners juggling a company, a family and a portfolio, that habit can add up to real trouble.

Taking Account of Mental Accounting

Mental accounting is the tendency to treat the same thing, money in particular, differently depending on where it came from or what we intend to use it for.

Consider this scenario. You buy a movie ticket in advance, but when you arrive at the theater, it is nowhere to be found. Would you buy a replacement? Now imagine it was cash in your pocket that went missing instead. Would you be as willing to spend more to make up for it? One study posed exactly this question and found that only 46% of respondents would spend additional money to replace a lost movie ticket, since they had already mentally spent that money, while 88% would spend again if it were cash they lost. Even though the two situations are effectively identical, our brains treat them very differently.

About 70% of people who receive a lottery windfall end up bankrupt, and the larger the windfall, the more likely they are to go broke.

Source: CNBC

Mental Accounting Can Lead People To:

  • Focus on the performance of one account or business line rather than their overall financial picture.
  • Hold rigidly to certain rules, such as always maxing out a specific account or always paying off debt first, regardless of whether it is the optimal strategy.
  • Feel most comfortable holding cash or low risk assets in one bucket while ignoring risk in another.
  • Treat a bonus, a big client payout or a tax refund very differently than a regular paycheck.
Is Mental Accounting Giving You Tunnel Vision?

Mental accounting rests on the idea that all money is interchangeable, yet we often fail to treat it that way, sorting our assets into distinct mental and sometimes literal buckets.

The tendency to treat windfalls differently is one of the biggest threats mental accounting poses to a family’s finances. It shows up in the striking rate at which lottery winners end up bankrupt, and in the fact that a large share of professional athletes deplete substantial fortunes within just a few years of retiring. For a business owner, it might show up as spending an unexpected sale or licensing payout on a luxury purchase instead of treating it with the same discipline as regular income.

Mental accounting also operates on a smaller scale. It can lead an owner to shortchange long term goals like retirement because they are too focused on the short term performance of one particular account or one part of the business.

About 33% of people, and 50% of millennials, plan to use their tax refund to pay for travel rather than savings or debt.

Source: Detroit Free Press

When Mental Accounting Factors Into Your Financial Plan

  • You might undercut your financial progress by treating certain inflows, like bonuses or windfalls, as more spendable than your regular income.
  • You may focus so heavily on one goal, like funding a child’s education, that you neglect a long term goal like retirement.
  • You might lock in losses by keeping money in low risk accounts while paying a much higher interest rate on debt elsewhere.
  • You could miss out on gains by paying off low rate debt faster than necessary instead of investing that money for a better return.
  • You might unintentionally trigger the wash sale rule, which applies across your accounts and your spouse’s, by selling a security for a tax benefit in one account and unknowingly repurchasing something substantially similar in another.
The Guardrail Against Mental Accounting

Mental accounting is one of the surest ways to keep a financial plan from reaching its full potential. While it is important to pay attention to the details, remember that the most valuable step toward your long term goals is often taking a step back to see the whole picture, your business, your investments and your family’s needs together.

It also helps to have a reliable source of objective information and guidance. Seek out perspectives that differ from your own and professionals with specialized expertise. As your financial advisor, I can serve as an unbiased third party, offering the perspective and comprehensive planning guidance you need to move toward the future with confidence.

Think Before You Act

  • Treat money with the same careful consideration no matter where it comes from or how you plan to use it.
  • Do not let your spending habits shift based on circumstance, whether you are on vacation or just had a strong quarter in the market or the business.
  • Talk with your children and heirs about what it took to build your wealth and what your wishes are for its future, so when the time comes, they treat it with the same care you did rather than as a windfall to spend quickly.

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