Mental accounting is a behavioral economics concept introduced in 1999 by Nobel Prize-winning economist Richard Thaler. He pointed out the different values people place on money, based on subjective criteria. Typically, mental accounting leads to irrational behavior and bad outcomes. However, it can be leveraged for powerful framing that can actually help you through the power of Stability PlanningSM.
The Dark Side of Mental Accounting
While I'm not technically a Jedi, I have learned quite a bit from Yoda. He once told me "Attachment leads to jealously. The shadow of greed, that is." I think he was trying to explain the dark side of mental accounting. You see, the mind plays tricks on us. All money is totally fungible. No matter what the purpose money has, it all has equal value.
An example of mental accounting mistake would be your savings plan and credit card debt. Imagine that you have $100 dollars a month to save towards your summer vacation next year. You also have $1000 of high interest credit card debt. Saving your $100 in a jar on the kitchen counter feels good. You dream about sitting on the beach soaking in the warm sun. However, you are going backwards. Those funds would have a better impact on your net worth if applied to paying down your high interest credit card debt.
You can also see this in how people treat "found money." It's never fun to owe the IRS money and pay taxes. Conversely, it's a dopamine boost when you get a tax refund. Too often, people take this $1000 and spend it on something frivolous. They didn't budget the funds, it had no place in their mental accounting so they buy a tech gadget or use it on a frivolous desire. The reality is that money was just as hard earned as all the other money they steward. But faulty mental accounting strikes again.
Use the Force of Mental Accounting
But you can perform a Jedi mind trick on yourself with the power of mental accounting as well. The way you see your fungible money can help you manage it with clarity and purpose. As Master Yoda often said, "Many of the truths that we cling to depend on our point of view."
One of the key tenets of Stability Planning is segmenting your money by purpose. We create three mental pillars:
- A Liquid Pillar: FDIC insured bank deposits.
- An Income Pillar: Funds that will create an income now or very soon.
- A Growth Pillar: Funds that need to grow to create income in five to ten years.
Over the last few years, I've noticed that when clients understand the purpose of their money they understand the performance of their money.
For instance, we know that our FDIC-insured bank deposits are going to get the going bank interest rate. In the current environment, they're nothing to write home about. However, the low interest is the trade off for the liquidity and peace of mind that they provide. We have money in the bank to spend right now and that requires safety, no volatility and complete liquidity.
In the Growth Pillar, we aren't looking for liquidity. We aren't looking for FDIC insurance. Our concern is that in 10 years, the money in the bank will run out and we'll need more to replace it. We are also concerned that our income stream will be eroded by inflation so we'll need to add to the income pillar. So we sacrifice stability, embrace volatility and remind ourselves of our ten year time horizon.
By knowing that the Growth Pillar is for a goal ten years hence, it helps us handle short-term volatility. Speaking with clients this year, I've been pleasantly surprised by the patience and purposefulness they've had towards their longer term goals. Here in September of 2020 it’s easy to forget that in April we didn't know how the market would respond long term to Covid 19. And the thing is, we still don't. The V-shaped recovery may turn out to be a W-shaped roller coaster. But that's okay, as long as you're spending money from your Liquid Pillar and creating income from your Income Pillar you'll be able to cope with the volatility that is part and parcel of the Growth Pillar.
Mental accounting is a force to be reckoned with and may the force be with you. Feel free to contact me if you have any questions.