I shared an article recently, in which I posited that having separate accounts for designated purposes is fundamental to a successful personal finance journey. I always recommend that everyone should keep at least 3 different accounts as follows;
– Transactional account; this should be funded for day-to-day spending
– Savings account to cover emergency funding and short-term goals like paying rent and saving for a holiday or wedding
– Investment account to secure your future money goals like building a trust fund for your children and retirement planning
This helps to keep you accountable to your budget and simplifies expense tracking.
Interestingly, someone noted that this concept is analogous to Mental Accounting in practice and in some respects, this is true!
In simple terms, Behavioral Finance proponents describe mental accounting as the tendency to create mental compartments for your money, thereby placing different values on money based on its source and intended use. For example, you might have treated yourself to a new phone just because you got an unexpected bonus.
You could also have budgeted $100 for entertainment in a particular month and find yourself splurging that money on stuff you do not need, because you realize that it is month-end and you are yet to spend it. You feel the need to use the money because it is already classified as “spent” in your head.
Mental accounting becomes a problem when it leads to biased decision making. Do you treat money differently, based on how you earned it? Are you quick to spend an unexpected cash gift and slower to spend from your salary because “Hey, what if I didn’t get that gift or what if I lost the money?” You might be exhibiting mental accounting bias.
Allocating your money to different accounts is a winner when it is goals-based and channeled positively. Mental accounting bias, on the other hand, can be bad for your long-term financial goals if it makes you impulsive with money you did not expect. Have you considered that the unexpected gift could go into your business or investment portfolio? You should not treat it differently!
Getting more organized financially can help you avoid mental accounting traps. Make it a habit to plan for your money and keep a working budget. If you have money in your emergency account, then it should be kept for emergencies. Any inflows, whether expected or not, should be considered holistically and worked into your overall budget. Remember that effective budgeting is in making progress and not perfection.
Finally, you should keep in mind that money is fungible – no one dollar is different from the other – and your money should work to help make your life better. Keep a large pool and allocate money to specific accounts in line with your financial goals. Every penny you get has a purpose, make it count!
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