You’re saving a little extra, but leaving your credit card bill to one side. Maybe you’ve also set-up your high risk investment account and your low risk investment account. You feel like you’re on top of things, but what you’re actually doing is mental accounting, and this could be damaging your overall wealth.
What is mental accounting?
Mental accounting describes the tendency of individuals to separate their money based on a range of subjective criteria. That could be the source of the money, so is it your monthly salary, inheritance, or a bonus. Or the function of that money, so do you use it pay your bills, for clothing, holidays, house savings, the list could be endless. Some individuals will separate this money either physically, or in their head, and then not use it across functions.
The function of money
We all have different financial needs and many of us will draw up a budget to cover those needs. This is not mental accounting, this is budgeting and something that should be encouraged. Mental accounting is when you set aside a certain amount of money for a specific event, like Christmas, or a holiday, and remove that money from your budget.
Some individuals go as far as to set this money aside whilst carrying credit card debt. This year the annual percentage rate (APR) on a credit card hit 21.6%; any saver or investor would be hard pushed to achieve this level of return over a sustained period of time.1 By holding on to credit card debt whilst saving, you actually end up decreasing your overall wealth. Which is why you need to look at your wealth as a whole rather than in separate pots.
The source of money
You might view a bonus that you receive from work as separate to your salary, but both contribute to your wealth, and both are viewed the same by the tax man. We can refer to this as ‘found’ money, and ‘earned’ money. Individuals are more likely to spend ‘found’ money, than they are ‘earned’ money. With ‘earned’ money individuals stick to a budget, but with ‘found’ money they’ll treat themselves, regardless of their financial situation.
If you view this logically then all money should be interchangeable, regardless of how you received it. Treating ‘found’ money separately to ‘earned’ money will ultimately erode the overall value of your wealth.
Mental accounting when investing
Some individuals also bring this approach to investing; having one low risk account, and another higher risk account. The problem is, you probably double your admin and work by doing this as you have to manage two accounts, but ultimately your overall wealth will not be any different than if you had one larger portfolio.
You need to remember that all money is interchangeable regardless of where it has come from or what it is for. Debt will most likely erode your overall wealth as interest rates are higher than those you earn on your savings or investments. And having a portion of your wealth in low or no interest cash accounts will do little to help grow your wealth over time. View your wealth as a collective and be clear on what you are trying to achieve.