In theory, we think of all money in the same way. In practice, we don’t.
Money is fungible. That means one dollar has the same value as another dollar or four quarters or ten dimes or 100 pennies. If you are buying something valued at $1.00, you can purchase it with $1.00 in bills or coins.
However, when making financial decisions, people tend to engage in something called mental accounting. One aspect of mental accounting is assigning labels that identify the intended purpose of money. Sometimes this decision-making shortcut can improve financial choices. Other times, it can produce a financial setback.
Mental accounting often guides spending and saving decisions
A common mental shortcut is budgeting. People and companies rely on budgets to help them make sound financial decisions. Typically, budgets allot specific amounts of income to spending and saving. For an individual:
Spendable money may go to housing, food, utilities, clothing, entertainment, and other expenses.
Saved money may go into emergency, vacation, retirement, or other savings accounts.
When people categorize money, they are reluctant to spend it on other things. Behavioral Economics reported, “When a resource [in this case, money] is divided into smaller units…consumers encounter additional decision points – a psychological hurdle encouraging them to stop and think…opening a partitioned pool of resources incurs a psychological transgression cost, such as feelings of guilt.”
In other words, your brain will be reluctant to spend your retirement savings on a vacation.
Some shortcuts lead to irrational financial decisions
Mental accounting is a double-edged sword. If people do not think flexibly then mental accounting can cost them. For instance, focusing too intensely on labels can result in decisions that hurt your financial position rather than help it. Kiplinger’s provided an example:
“Mental accounting leads us to hoard money in a savings account that earns 0.3 percent interest while keeping a high balance on a 15 percent-interest credit card. We like the psychological comfort we get from having money in the bank, even though transferring cash from savings to pay off a credit-card balance can essentially ‘earn’ us a quick 14.7 percent.”
Like many things, mental accounting can be helpful or hurtful, depending on how it’s applied.