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Mental Accounting: Use It to Your Advantage

When you get an unexpected bonus or a tax refund, do you splurge or make an extra mortgage payment? For many of us, splurging is the more tempting option. Attaching different values to money depending on where it came from or where you keep it is a common tendency. Economists call it “mental accounting.”

When investors talk about mental accounting, the conversation often focuses on the potential downsides. We are told to be on guard against mental accounting and to consider our money fungible, with a dollar here no more valuable than a dollar there.

And it’s easy to imagine scenarios where mental accounting might lead you astray. For example, an investor who sets up two investing accounts—a “safe” one that is overly conservative and a speculative one that takes outsized risks—might find him or herself in a worst-of-both-worlds situation of hobbled growth potential and increased volatility.

But this doesn’t mean you can’t use mental accounting to your advantage.

“Mental accounting is just one of many mental shortcuts we use to live and manage our affairs,” says Mark Riepe, Senior Vice President at the Schwab Center for Financial Research. “It can hinder you in some important ways, but mental accounting can also be helpful. It’s all about how you channel the impulse.”

In other words, there are a few pros to balance out the cons. So what are they?

Goals-based investing

Having specific goals for specific accounts is one potentially positive form of mental accounting that may already be familiar to many investors. For example, if you have an account geared toward saving for retirement, one for college savings and a third to serve as an emergency reserve, you’ve likely already assigned a timeline and risk tolerance to each account, and selected investments that are right for each goal. If your retirement is still decades away, you might have more equities in your dedicated account. Meanwhile, your emergency reserve might hold less-risky investments or cash.

This “bucketing” approach is particularly useful for investors nearing retirement. As their focus shifts from saving to spending, many retirees need to tap their investments to pay their bills. Schwab suggests setting up three buckets to manage this transition: one containing cash and short-term reserves, a second short-term reserve with income-focused investments that generate predictable interest and dividends, and a third longer-term portfolio aimed at generating capital gains.

“One of the nice things about mental accounting is that it encourages you to really think about each account and what you’re trying to achieve with it,” Mark says. “Any mental trick that clarifies this in your mind gets you one step closer to achieving your goals.”

Of course, mental accounting can become a hindrance if investors have too many goals to keep track of. An investor who has 15 different priorities and considers them all sacrosanct is sure to fall short somewhere.

“You have to pick a few goals,” Mark says. “Otherwise, it’s too confusing and too cumbersome to manage.”

Consolidating assets

Using mental accounting can be helpful when it comes to consolidating accounts that are focused on the same goal—say retirement.

For example, some investors accumulate multiple retirement accounts as they change jobs over the years. But rather than folding them all into a single account that they can monitor and manage holistically, some investors just keep them separate. Maybe they check their statements to see how the different accounts are doing, but it can be difficult to maintain a clear picture of allocations and risk when investments are spread far and wide.

Consolidating accounts according to their goals is a simple way to bring order to your finances.

Regular check-ins

Mark says using mental accounting to separate and focus on each goal has another benefit: “It encourages investors to periodically check in and see how they’re really doing.”

Too often, investors measure their performance against broad market benchmarks like the S&P 500® Index. While that might be helpful up to a point, measuring your performance against the broader market won’t tell you how you’re progressing toward your personal goals.

“Checking in on your goals allows you to see not only how your investments are performing, but also whether your mix of investments is still appropriate and whether you’re contributing enough to stay on track,” Mark says.

Regular check-ins make it easier to identify and implement necessary adjustments. For example, if the price of a college education rises faster than you planned for, you might respond by cutting back your spending, increasing your regular contributions or (if your time horizon is long enough) shifting money into riskier assets that may generate higher returns.

“Having the money in a dedicated account gives you the freedom to home in on your goals and the flexibility to alter your plans as needed,” Mark says.

“Mental accounting doesn’t have to be a negative influence on our decisions,” Mark says. “It’s natural for us to assign different values to different buckets of money. Rather than trying to work against our instincts, we can use discipline and the right approach to make this behavioral quirk work in our favor.”

Visit Schwab's Facebook page at facebook.com/charlesschwab and tell us what kinds of mental accounts you have set up in your life.

Mental Accounting Pitfalls

While mental accounting can be beneficial in certain situations, it can also be detrimental if you’re not careful.

For example, imagine a person who receives a bonus at work, and instead of saving it or paying off a debt, he treats it as “fun money” and spends it on a lavish vacation. In this case, he’s exhibited the negative effects of mental accounting by viewing the windfall as separate from his normal income. If he viewed all of his money equally, he might have found a more prudent way to use his bonus.

To avoid the pitfalls of mental accounting, make sure to consider the most financially beneficial way to use your money regardless of income source. If you have debt or other important financial obligations to attend to, take care of those before spending on discretionary items like vacations and home improvements.

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Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

The S&P 500 Index is a market capitalization-weighted index comprising 500 widely traded stocks chosen for market size, liquidity and industry group representation.

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