The Fallacy of "Mental Accounting"

Mental accounting is a pet peeve of mine. It's a terrible habit that we're all guilty of from time to time. What is mental accounting? Here's an example:

"Well we didn't spend much on dining out this month and our tax return is going to show up next week, so let's splurge on that 32" LCD TV for the bedroom."

Look -- if you want to buy a fancy television, then just buy it. Don't rationalize the purchase by tallying up other areas where you saved money. All of your finances really live in one single bucket. Seperating out particular ups and downs causes you to miss the bigger picture.

Instead, look at your cash flow needs and savings rates and decide if you can afford the purchase. If you can, then ask yourself if the new purchase is worth the asking price and worth giving up the future revenue stream that those purchasing dollars could generate. Then ask yourself if those dollars would be better spent on something else. If the purchase still seems like a good idea, then just do it. There isn't a single other criterion that should enter into the decision.

The trouble with mental accounting is that is destroys forward progress. Every time you manage to save a little extra money here or there, you rationalize it away by spending an equal amount here or there. Mental accounting is a pernicous habit that permeates much of what we do. Whether it's in the realm of personal finance or even dieting and exercise, try not to nullify your good decisions with an equally bad decision. The sum is just zero - right where you started.

One of the ways to prevent yourself from falling into the mental accounting trap is to keep a monthly balance sheet. The beauty of a balance sheet is that it forces you to look at your whole bucket of dollars. That last line on your balance sheet that computes your net worth doesn't care where the money came from or where it went. All it cares about is the big picture and the bottom line.