All Business & Investing Economics Psychology

Saving through Mental Accounting

A 2016 CareerBuilder survey of 3,200 full-time workers and 2,100 full-time hiring and human resource manager found that 75% were living paycheck to paycheck. It’s not that working people don’t want to save; over the past two decades Americans consistently say we prefer saving to spending.

While we know what we should do, the rational part of our brain usually does not make the decisions when the time comes to it. We are instinctively and societally wired to think that material purchases will make us happy and crave that satisfaction immediately. The advent of marketing and technology entices us to spend more – often of what we have.

Moreover, research finds that while we estimate routine purchases well, we underestimate “special occasions.” So, when a wedding anniversary, or we’re presented with an exciting but expensive opportunity, we splurge, thinking of it as a rare occurrence. But these “rare occurrences” aren’t as rare as we think. When we fail to factor all these exceptions into our budgets, we overspend, making it harder to save.

When used responsibly, credit cards are a valuable financial instrument that allows us to “smooth” consumption. We borrow from the future during lean times (or before we get paid) to maintain a constant standard of living. Still, this assumes that we will make enough next month to pay for this month as well as that month. Otherwise, we get caught in a cycle of expensive credit.

Although the relationship between income and happiness is weak, there is a strong relationship between happiness and difficulty of paying bills.  Households with more debt exhibit lower happiness and more marital conflict. In other words, what we owe is a bigger predictor of our happiness than what we make.

Goals-based investing focuses our attention away from the routine and unto the special, rare, and future events.

Mental Accounting

Wealth is the sum of all assets and net future cash flows less liabilities. However, most people do not think of money as fungible. Instead, we compartmentalize everything into separate, functional ‘mental accounts’ based on criteria such as the source of the money and intent for each account. For example:

  • Having a special “money jar” or fund set aside for a vacation or a new home, while still carrying substantial credit card debt. The money jar is treated differently from the credit card debt, even though diverting funds from debt repayment increases interest payments and reduces net worth.
  • Spending more “found” money, such as tax returns and work bonuses and gifts, compared to a similar amount of money that is normally expected, such as paychecks. Regardless of the money’s source, spending it will represent a drop in overall wealth.
  • Dividing investments between a safe investment portfolio and a speculative portfolio to prevent the negative returns of the speculative investments from affecting the entire portfolio.

Goals-based Investing

By not thinking holistically, people miss out on optimal choices and on the benefits of risk diversification. Goals-based investing marries Modern portfolio theory with investor behavior. Goals (Mental accounts) structures portfolios so that each financial goal is funded and invested independently.

Savings goals can be grouped into three types:

  • SPECIAL – Individual Goals: From gifts to trips to major purchases, these types of spending add flavor to our lives. By mindfully setting these ways in accordance to scientific findings we can live happier and fuller lives.
  • RARE – Emergency Fund: This is liquidity –access to money – as needed and is the cushion that will help you through any ‘rainy days’ in life. If there ever comes a time when you need some money at short notice, your emergency fund can act as a safety net. Financial security keeps stress at bay and avoid the traps that expensive credit card debt can lead to.
  • FUTURE – Retirement Planning

Saving for any of these should be balanced with living a fulfilling life and investing for retirement.  In addition to routine spending, existing credit and prospective debt should be considered. Credit card rates are much higher than most investments can produce, and so should be paid off before saving money. Lower rate debt, however, should be evaluated according to your individual circumstances.

What do you think?

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