Mental accounting refers to our tendency to separate our money into different accounts based on subjective criteria: the source of the money (money easily earned is not treated carefully as our salary, for instance), intended use for each account (‘play’ money, money to lose in investments etc.).
We already found out how mental accounting can negatively affect our finances, so it’s time to find out how to minimize its influence.
How to stop mental accounting
Organize your finances
Look for a budgeting system.
You can use a simple excel spreadsheet, an online app (such as Personal Capital or Mint), even a computer installed software such as the old You Need a Budget App or, my favorite, AceMoney.
Whatever you choose, create categories for your income and spending and start tracking your money.
And do it diligently month after month.
Understand how your budget works
Blindly tracking your income and expenses is just futile, if you can’t understand your money behavior, how much you earn on average, how much you spend on average, what’s your biggest money drain etc.
In few months you’ll notice that you probably overspend on groceries and earn too little. Or any behavior that you can take from your data.
This allows you to set up an emergency fund, if you don’t have one already, curb your spending on some categories or allocate more funds to the ones you feel important (such as travel, for instance, or education).
Set goals
The best way to keep prepared for any windfall or avoid mental accounting is to have some life goals.
- Short-term goals – pay off your car. Pay off your credit card debt. Save for an emergency fund. Save money for a new guitar or a scooter for your teen-age boy. Maybe fund a nice vacation for the family. You surely have something in mind for near future, plan accordingly.
- Long-term goals – pay off the mortgage. Save for retirement. Retire early on a secluded island. With long-term goals, you’ll need to further break them into smaller ‘bits’ and then see what you need to accomplish step-by-step to achieve the main goal.
Think about what you’ll do with the extra money.
A lot of the mental accounting issues come from not being prepared mentally for your windfalls.
Before your boss gives you a bonus, auntie Dorothy leaves you a small inheritance or you win some money at the lottery, think about what you’d do if you had that extra money.
Would you speed up debt payment? Would you invest in further education? Pump up as much money as you can into your retirement funds? Buy a house in Italy?
Chances are that, when luck strikes, you’ll know what to do with that extra money and not just squander it.
Respect your money
I come from a very poor family and was raised to hate money.
It was something we never had enough anyway, so why not dislike it?
Rich people? Yuck. Money? Double-yuck.
As you can guess, this didn’t allow me to achieve too much in life, since I never cared for my money. Then, at about 30, I started reading more about personal finance and a book changed my life: The Millionaire Next Door.
This showed me that keeping up with the Joneses (something I had done for years) was not a lucrative way to spend my life and that money does matter.
I started liking money more (it’s mine, coming from my own work, why hate it anyway?) and money started loving me back. Yeah, it sounds weird, but I started becoming more successful financially speaking, only after respecting my money.
Respect your money, too.
You are working for it. You are sacrificing years of your life, family time and energy.
Get someone to keep track of your progress
We call them accountability buddies and they help us keep on track by having to report to them every once in a while. Are you on a diet? Keep your spouse informed with your progress. Trying to quit smoking? Again, have someone to see if you are still on the bandwagon.
If this strategy works in so many cases, having a money buddy would work great as well.
Choose your partner or a close friend. Share your problems and goals, see how you can solve all your issues and stay on track.
As soon as you feel like you are gonna fall into the money accounting trap, discuss it with your accountability buddy and see how you can do better.
