Humans seem to require some semblance of structure in their lives to function well (er, most humans seem to anyways). As a species we tend to like categorising and counting things. For the individual, this tends to gives rise to mental accounting within their personal finances.
What is mental accounting? This is the phenomena whereby we give our individual £s objectives and goals; we even divide them up into neat little buckets.
What is so bad about mental accounting?
The three major reasons to unlearn this behaviour are:
- It will lead to improper asset allocation across your entire portfolio, likely costing tens or hundreds of thousands of pounds in the long run and skewing your risk tolerance for better or worse.
- It can cause feelings of guilt, stress and anxiety that could otherwise be entirely avoided.
- Removing mental accounting tendencies will simplify your finances and make automation a whole lot easier.
Great, shall we begin?
Mental accounting needs to be avoided like a bad disease, yet it seems to be one of the very first ‘financial lessons’ we pick up in life. I certainly used to do it by accident, without realising it.
See if this sounds familiar:
Take Sally. Sally practices mental accounting without realising she does it.
She has a few little tubs on the mantelpiece labelled ‘Rainy Day’, ‘Christmas’ and ‘Holiday fund’ – she drops coins and notes into them here and there and when they fill up, she’ll empty them and spend them (that’s the whole reason she was saving of course!).
Take John next. John is a little more tech savvy than Sally, so what he does instead is keep his money in several different bank accounts, rather than in a physical format.
He has a main current account for monthly bills, another for spending money and a final one for groceries and household bits. He has a savings account for his ’emergency fund’, a savings account for his ‘holiday fund’ and another one for his ‘Christmas fund’. Much like Sally, the point of these accounts is obvious. If he has an emergency, it gets pulled from that account. The Christmas purchases will come from there and so on and so forth. John even has these organised into a spreadsheet that looks something like this:
On the face of things, this appears to be a logical and simple way to divide up a financial portfolio (portfolio meaning everything you’ve got, from cash to stocks). This is certainly a better way to live than to have no idea what expenses are coming up, so it’s definitely a step up from having no budgeting solution at all.
What should we change about this approach?
For the ‘Day-to-day’ or green heading, I have no complaints or revisions to suggest. Allocating monthly living expenses in this fashion is absolutely fine and comes stamped with a ‘Mr Fox approved’ label. I do something similar and it works well for my needs.
The mental accounting issue crops up when we look at those yellow and red coloured headers. If we throw a proverbial spanner into the works, we can begin to see why this approach to savings lacks efficiency and begins to cause headaches.
Imagine that John arrives home and finds out his fridge has conked out. It’s past the warranty and a quick repair isn’t going to be possible. John breathes a sigh of relief “The emergency fund will cover that, that’s why I have one!”. Setting aside £300 for a new fridge, John revises his emergency account down to £350. A further disaster strikes the day after and John needs to pay out £400 immediately. Very unfortunate timing but by no means implausible. John knows he only has £350 remaining in his ’emergency’ bucket. This dilema therefore causes a knock on problem – where does he source the additional £50 from? Does he raid his S&S ISA? His holiday fund he has worked so hard to get together? Christmas is right around the corner, surely he can’t take it from there?
The other major issue with this approach is less obvious; John’s risk tolerance is way off from what he wanted (and he probably hasn’t even noticed).
Many months before, when John sat down to invest his first £100, he did his research through and through. He decided his ideal risk tolerance would be 80:20, stocks:fixed income, rebalancing with a +/-5% trigger. Looking at his current wealth of £750 in stocks, we can see this comes out to 83% of the total value of his S&S ISA. This means he is on track, right?
By practicing mental accounting, John has forgotten to factor in his ‘savings’ buckets to the calculations. If we sum these buckets of cash alongside the S&S ISA, we can see that John’s £750 in stocks represents a meagre 38% of his wealth. This is significantly more conservative than John wanted to be. So we see the dangers of mental accounting – we can miss the bigger picture of our finances completely.
What are the take home messages?
It’s a matter of personal taste, but I’m a fan of simplicity. Fewer accounts means fewer things to track. I’m not suggesting we bury our heads to upcoming expenses, simply that we need to avoid falling into the trap of giving each £ a job when it can be used interchangeably. Holiday funds can be liquidated into Christmas funds and back into emergency funds as the situation requires; so there is no reason to save for these types of things individually.
Tracking goals is an excellent way to stay motivated, but make sure you evaluate everything in your portfolio properly. Cash is cash, regardless if it is ‘in your investment account’ or not.*
Set your asset allocation and get investing!