Last year’s holidays may seem like the distant past, but your wallet remembers as if they were yesterday. This time around, your New Year’s resolution won’t be to lose weight, but rather to gain control of your finances. And you think you know just how to do it… by putting the family on a tight budget! But what if that’s not such a good idea?
myLIFE is back again with another article about good financial habits to help you manage your spending and investments. This time, we will delve into the concept of mental accounting to see why making your family budget too strict is a sure-fire way to spoil it. Once you’re well informed, take the time to explore our lists of budget pitfalls to avoid and fundamental rules for smarter budgeting.
Everyone needs a budget
To manage their daily finances, most individuals or couples practice some form of accounting, either with pre-defined limits or relative ones. Just like a company, you can make a financial plan that accounts for current and future income, savings, accrued liquidity, and necessary spending and investments. Then, you simply have to allocate the available funds to the different spending categories. This means you have to prioritise your costs, without forgetting to save for future plans and make sure you can bear any unexpected financial burdens.
All our lives, we are encouraged to engage in this sort of planning, from the childhood piggybanks we fill to buy candy, to the student jobs that fund our first holidays as adults. (And remember that financial advisers are always ready to help too, especially when it’s time to plan to buy a home!) But why do so many budgets fail? The answer often lies in how they are designed.
Generally speaking, household finances can be split into three parts: liquidity (held in bank accounts), expenditures (grouped by purpose) and income (divided into streams based on regularity).
Mental accounting and the art of grouping income and expenses
Generally speaking, household finances can be split into three parts: liquidity (held in bank accounts), expenditures (grouped by purpose) and income (divided into streams based on regularity). Once the broad strokes have been established, each person tries to label their cash inflows and outflows by creating more or less specific budget categories depending on their lifestyle. The goal, of course, is to make it easier to keep track. For example, you might make a category for food, holidays or clothing. It’s also important to regularly review your family’s financial plan to ensure you’re staying within the limits you’ve set.
You may be unaware that there is now a specific name for this type of categorisation: “mental accounting”. This phenomenon was largely described by Richard H. Thaler, who received the Nobel Prize in Economic Sciences in 2017 for his work in behavioural economics. He defined mental accounting as “the set of cognitive operations used by individuals and households to organise, evaluate, and keep track of financial activities”.
Mental accounting is “the set of cognitive operations used by individuals and households to organise, evaluate, and keep track of financial activities”. (Richard H. Thaler)
In performing mental accounting, families and individuals evaluate their income and activities, creating mental accounts in which funds are assigned to specific expenditures linked to particular categories. Each household expenditure must then be labelled in order to arrange them neatly in the various mental accounts. Finally, the health of these mental accounts must be reviewed at predetermined intervals. This is the essence of budgeting.
There are many advantages to managing money this way; for example, it allows individuals to compromise and choose wisely between different spending categories when the available funds make such decision-making necessary.
The system also has a built-in safeguard to maintain control of your finances by exercising discipline with respect to financial commitments made previously. In terms of planning for recurring costs, it is designed to enable a household to weather a major financial setback or unforeseen expenditure. And it even leaves room for small pleasures when there is something left over.
The limitations of mental accounting
Ultimately, mental accounting seems to make perfect logical sense as long as we maintain an accurate picture of our total household funds, income streams, spending habits and running costs. In this respect, mental accounting is simply a rational approach to managing and skilfully adapting a budget. But is it still useful if we haven’t truly mastered anticipating our spending habits, or balancing the mental categories against one another to keep our budget reasonable and realistic? The answer is no.
Keeping multiple mental accounts would be a good solution if we could only manage to remember that the funds we put in each category are perfectly interchangeable. The problem is that in our minds, they aren’t… and this can make the whole exercise counter-productive. Why? As Thaler explains, our intuitive mental accounts go against the fundamental economic principle that money is fungible – in other words, that one euro is just as good as another, and so placing it in the food category now does nothing to prevent us from moving it to the leisure category later. Mentally, this is something we have trouble doing. That’s because making these categories can create imaginary barriers.
Households that do mental accounting while strictly separating their spending categories trap themselves in an inflexible system of non-transferable budget items. A strategy with strict categories also has a direct impact on spending choices and daily quality of life. People who take this approach may forego a holiday while, in another part of the budget, they’re storing excess in a savings account that doesn’t generate value.
The problem is that consumers have the frustrating tendency to want to categorise all incoming and outgoing funds, even when the context doesn’t allow for the tidy labelling of surprise expenses or windfalls. The system that is supposed to simplify a family’s financial planning thus becomes highly complex – so much so that small things may even be forgotten, like the money spent daily on coffee before work. In straining to track things in unnecessary detail, we can lose sight of the big picture: our long-term household wealth.
It may sound counter-intuitive, but a strict budget that is set in stone is no good to the person keeping it.
Inflexibility breeds absurdity
It may sound counter-intuitive, but a strict budget that is set in stone is no good to the person keeping it. Of course your budget should have structure, and will have to be restrictive enough to prevent impulse spending. But at the same time, it should also be flexible enough to let you transfer funds from one mental account to the other if you need to.
Take this backwards situation that is sadly commonplace in large companies: a few months before the end of the financial year, one department finds itself over budget while another is still well in the black. But instead of seeing the big picture, the second department opts to spend what’s left on useless purchases for fear of seeing its budget reduced the following year.
A similar phenomenon can occur in the home. A totally inflexible budget can lead us to over-consume things we don’t really want, even when we can’t seem to afford the things we do. For example, suppose someone puts money aside to buy a new sweater during the winter sales. If they can’t find what they’re looking for, they might still feel compelled to spend their sales season budget on clothes they don’t actually need. Suppose this same person is a budding gourmet, and yet they avoid nice restaurants that month simply because their leisure budget is already gone.
This might seem like a special case, but if the same thing repeats itself for different mental accounts, these strict categories can be disastrous to a person’s quality of life. What’s worse, they can even hurt the wealth of the household; for example, when a family decides to buy a home by taking out a high-interest loan instead of using funds that sit inactive in a savings account.
At the end of the day, it’s all a question of balance – of finding a budget that is neither too lax nor too strict. Richard Thaler recommends that households build sufficient flexibility into their budgets, and that they review them regularly enough to allocate funds in an optimal way for serving the family’s interests.