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Wealth Watch: Explaining mental accounting

Mental accounting is a tendency that people may have to think of their money as separated into different accounts for different purposes, instead of one collective whole. Ask yourself if you have a special bank account for a future trip, or keep lots of money in a bank account while also carrying debt, or if you have a specific bank account for morning coffees. It is something many of us are guilty of and may help with decision making but it can also lead to an irrational thought process.
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Mental accounting is a tendency that people may have to think of their money as separated into different accounts for different purposes, instead of one collective whole. Ask yourself if you have a special bank account for a future trip, or keep lots of money in a bank account while also carrying debt, or if you have a specific bank account for morning coffees. It is something many of us are guilty of and may help with decision making but it can also lead to an irrational thought process.

One example of mental accounting is using a “money jar” or special bank account for the purpose of a future family vacation while also carrying balances on high-interest rate credit cards. While the concept is sound it makes far more sense to pay down the credit card and then travel once you’ve paid off enough debt. The thinking is straightforward; you’re earning no interest (or little) on the money saved for the vacation, but paying high interest on your credit card. The irrational thought process of paying interest on money you have elsewhere is damaging in the long-term.

Another example of this is how people react when they get their tax refund. The thought process is that this money can be spent readily, because it wasn’t there before and can now be used for whatever we want. At the same time, if you’re carrying high-interest debt or are not saving for the future, you’re potential compounding a problem. The thought of spending “found” money is very prevalent, but creates a bias leading to irrational thinking.

I often see this thinking when individuals begin taking payments from the Canada Pension Plan (CPP). Often, if individuals are taking it early (before 65) they are doing so at a lower payment but with a goal in mind, like using the funds for a car payment, or to pad their savings account. The reality is that they could be using the funds they already have saved in other account to do the same while letting the CPP payments increase in value. The compounding effect of higher CPP payments later in life can provide far more value than the mental accounting approach of using the government’s money first, before using your own.

Another approach to mental accounting is when people invest very conservatively in their children’s Registered Education Savings Plan (RESP). The point of the RESP is to save for the future education of your children, which is a worthy cause. Often, investors relate the account back to the protective nature they have over their children. In short, this account ends up being treated differently than other investment accounts for no other reason because it’s linked to their children’s future. As a result, some investors ignore the 10-20 year time frame that they may have to invest, and instead opt for an ultra-low risk investment to ensure that their children’s money is protected. This irrational thinking can lead to far lower returns in the long-term, and potentially not meeting the objective.

For investors, mental accounting works in ways where they may have a “fun-money” account where they invest in high-risk positions. The thinking is that if they lose in that account, it doesn’t affect their “real” money elsewhere. The net effect to their wealth is the same, however. The reality is that they are using mental accounting to justify their activity in one account, while ignoring the total effect these decisions have on their net wealth (good or bad). This doesn’t mean investors shouldn’t invest aggressively, but it does point out that mental accounting can create irrational thinking when it comes to the source and purpose of the funds.

There are many interesting facets of behavioural finance that can create biases relating to the way we think and act about money. Mental accounting is a common bias that has many examples. Consider looking at your personal finances to see the way you think of your money as different parts, instead of a sum of one whole and ask yourself if the thinking is rational.

This is for information purposes only. It is recommended that individuals consult with their financial advisor before acting on any information contained in this article. The opinions stated are those of the author and not necessarily those of Scotia Capital Inc. or The Bank of Nova Scotia. Scotia Wealth Management is a division of Scotia Capital Inc., Member Canadian Investor Protection Fund.

Happy investing,

Derek Fuchs

Senior Wealth Advisor

Scotia Wealth Management