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How mental accounting affects the way you spend

Financial planning
21 September 2018
How mental accounting affects the way you spend

Do you ever think about money differently depending on where it comes from or how you plan to spend it?

When a dollar isn’t a dollar

The value of a dollar should be the same, whether it’s given to us, or earned through work, right? But we often find it easier to rationalise ‘splurge’ spending when the money comes from an irregular source, like an annual bonus or tax return, compared to our savings or regular income.

Researchers call this ‘mental accounting’1. It explains why we tend to separate our money into different ‘buckets’ in our minds, and treat each bucket differently depending on its source or purpose.

 Let me give you an example

We tend to place our regular income into our ‘everyday living expenses’ bucket and use it to pay for things we need, such as groceries and bills.

On the other hand, money received from an irregular source can feel like ‘free’ money, making it easier to allocate to a ‘discretionary spending’ bucket. We often spend this money on something we want rather than need (and would feel too guilty paying for it out of our ‘everyday’ bucket).

The pros and cons of money buckets

An upside of mental accounting is that it can help us focus on our future goals. How? We can take steps to make it easier to visualise what the money is for, which helps us resist the temptation to use it for anything else. For example, re-naming your savings or investment account to match your savings goal (such as a new car, house deposit or children’s education).

However, this process can also have unintended negative effects. For example, if you have savings in the bank earning around 2% p.a., but your credit cards aren’t paid off and are costing you anything from 12–22% p.a.,2 then you could be paying more interest than you’re earning.

Making the most of your irregular money

Imagine you received a pay rise of $200 per month. We’d usually allocate this extra money to our ‘everyday living expenses’ bucket, and possibly reward ourselves with a small gift. But what if you received the pay rise as a lump sum of $2,400 at the end of the year instead? We might be tempted to put the extra money straight into the ‘free’ money bucket, making it easier to spend.

Each tax season, many of us are looking forward to receiving (or spending!) our tax return. However, it may be worthwhile to take time and think it through. With the average tax refund in Australia now over $2,500,3 it’s like saving $200 per month from your regular income. If we recognise that tax returns are effectively extra savings, using that money wisely could be a great way to improve your financial future. Rather than mentally allocating all your tax return to the ‘discretionary spending’ bucket, consider also paying your future self by investing some of the funds or reducing debt.

Some clever mental accounting today could make a big difference – now and down the track. But don’t be too frugal. Buying yourself a small gift is a fair reward for making the most of your tax return each year. After all, you earned it.

About the author

Dr Campbell Heggen is a behavioural researcher and financial planning academic at Deakin University. Campbell is a curious guy. Not satisfied with knowing what financial decisions people make, he wants to know why and how we make these decisions, so he researches what motivates and influences our behaviour.

Campbell is writing a series of articles for CareSuper exploring our attitudes and behaviours towards financial planning.

Information provided in this document is from a third-party source. While we believe this information is reliable, we take no responsibility for errors or omissions.

References

1Thaler, R.H., 1999. Mental accounting matters. Journal of Behavioral decision making, 12(3), pp.183-206.

2finder.com.au ‘2018 State of the Credit Card Market Report’

3moneysmart.com.au, ‘How Australians spend their tax returns’

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