When I studied for my CFA exams (level 3 specifically), I learned about the behavioural biases of individuals. It turns out we’re not 100% rational, who knew? One of the biases that really stuck with me was the mental accounting bias.

“Mental accounting” is a term very commonly used in the Lazy FI household. it is most commonly used in the phrase “We don’t use mental accounting in this family”.

What does mental accounting mean?

No, it’s not what an accountant hears from his manager after a job well done. Although I have met some accountants who are a bit mental.

Based on Investopedia: “Mental accounting refers to the different values a person places on the same amount of money, based on subjective criteria”

In simple(r) terms, Mental accounting is when people treat one sum of money differently from another sum of money (although they are of equal amount) based on which mental account they assigned that money to in their mind.

Let’s do some examples and it’ll make more sense.

Examples of mental accounting

Example 1- Unexpected bonus

Scenario 1

Let’s say you had £5,000 in your current account just before payday. Your net salary is usually £2,000 a month. However, this month you got £3,000. £2,000 is your normal salary and £1,000 is an unexpected bonus from your employer.

You just got paid so you now have £8,000. How likely are you (from 1-10) to spend that £1,000 on a nice holiday, a new gadget, or some other expense “to treat yourself”?

Scenario 2

Now let’s say you had £6,000 in your current account just before payday. Your net salary (just like every other month) is £2,000.

You just got paid so you now have £8,000. How likely are you (from 1-10) to spend that £1,000 on a nice holiday, a new gadget, or some other expense “to treat yourself”?

Results

I’m guessing that most of you said they are more likely to spend in scenario 1.

But why? in both cases you now have £8,000 and you’re considering a £1,000 spend?

This is because of mental accounting. We assign different “accounts” to sums of money in our minds. Our current account and regular paychecks are “planned” and will therefore be used for day-to-day expenses. However, the bonus is assigned to the “unexpected” account, which we didn’t plan for so we’re more likely to spend it.

This is an example of how mental accounting can increase our expenses.

Let’s do another example.

Example 2- Credit card debt

Scenario 1

Let’s say you have £3,000 in your current account. You decided to have an “emergency fund” of at least £3,000. This means you don’t want to go below that balance.

You also have £2,000 in credit card debt (god forbid). That debt carries a 25% annual interest rate (like the 25% American express has, see last week’s post).

How likely are you (from 1 to 10) to pay your credit card off? What if the interest was 5% instead of 5%?

Scenario 2

In this scenario, you have £1,000 in your current account. You also decided on an “emergency fund” of £3,000 (you’re working your way up to it).

How likely are you (from 1 to 10) to borrow the £2,000 at a 25% annual interest rate to fill up your “emergency fund”? What if the interest was 5% instead of 25%?

Results

In both scenarios, we’re choosing between a £1,000 balance in our current account and a combination of a £3,000 balance + a £2,000 loan/debt

However, I’m sure you were more likely to choose the £3,000 balance + a £2,000 loan/debt option in scenario 1 than scenario 2. Why is that?

In scenario 1, the £3,000 are already (mentally) allocated to your “emergency fund” mental account. That’s why you are less likely to use it, even to pay off a 25% (or 5%) interest rate debt.

Mental accounting in the Lazy FI household

For me and Lazy FI Mum, mental accounting comes into play regarding my side hustle money**.

Since my side hustle (teaching Excel) has been picking up, I feel a lot more comfortable spending money. This can be eating out, going out, holidays, or buying stuff. If I had a higher salary, I’m not sure I/we would spend that money. This shows I am also susceptible to mental accounting bias.

Am I going to change this? probably not.

The first reason is that I’m human and irrational. I can not change this fact. Admitting this is more painful than you think.

The second reason is that I’m very happy with our saving rate. I mean… we did hit a saving rate of 54.19% in 2021. Funny enough, this is also an example of mental accounting. Anything over the 50% saving rate is in the “ok to spend” mental account.

So if you’re ok with it, what’s the problem? And why do you say “We don’t use mental accounting in this family”?

Different mental accounting

The fact that I classify a certain amount to a specific mental account doesn’t mean Lazy FI Mum classified that money to the same mental account, and vice versa.

Different mental accounting- example 1

Lazy FI Mum said I eat out at Nando’s* with our daughter too often. I told her I feel OK to spend that money because the side hustle money covers it.

Lazy FI Mum: “We don’t use mental accounting in this family!”

In her mind, she had other plans for that money. Even though we probably had enough in our current account for her other plans, this money was already allocated to a different mental account.

In addition, even without her plans for that money, she thought (and still thinks) we visit Nando’s too often. It’s an unnecessary expense regardless of where the money came from. Fair enough.

I wish I could say “I’m typing this post from Nando’s” haha. That would have been epic.

Different mental accounting- example 2

Another example is that Lazy FI Mum wanted to spend a (relatively) large amount of money on something, I think it was a friend’s birthday gift or something. I told her the amount seems high. She said she felt OK spending that money because the side hustle money covers it.

I said (everyone together now): “We don’t use mental accounting in this family!”

That annoyed me a bit. The thought of me teaching Excel for hours just for that money to be spent on something I disagree with was unsettling.

However, if she hadn’t said that, I would’ve assumed it came from our “regular” money (salary or whatever) and the conversation would’ve been a lot different. In the end, she spent that money on whatever it was (honestly can’t remember).

Once I realised I was getting annoyed just because of mental accounting, I did a small mental shift in my head.

What can you do about mental accounting?

I think the biggest thing you can do about it is to be aware. Once you’re aware, you can maybe spot in time and “correct” your actions or your approach.

Another thing you can do is prepare a set of rules in advance to “protect” yourself. For example, you can agree (with yourself or your partner) on a specific budget for eating out. Just make sure you don’t make an effort to spend the full budget 🙂

Summary

As we saw in the “Examples of mental accounting” section above, mental accounting can really hurt you financially. It can cause you to spend more (in example 1) or pay too much interest (example 2).

It can also cause disagreement between you and your partner.

If by reading this post, you will be more aware of this behavioural bias, my mission is accomplished.

Notes

* Forget about Disneyland, Nando’s is the happiest place on earth! This blog is not sponsored by Nando’s but if you work for Nando’s and reading this- I’m open to the idea.
**All the money we have is “our money” the word “my” here refers to the side hustle.