Have you ever gotten a tax refund and thought, "Whoo hoo! Free money!" while simultaneously carrying credit card debt (or some other liability)?
Behavioral scientists describe this phenomenon as mental accounting. It's considered a decision-making bias because it doesn't recognize that money is just money—the accounts we keep it in are completely made up. In other words, while you might be excited to have money from a tax refund, it isn't strictly separate from your credit card debt or your finances as a whole.
The behavioral finance giant Richard Thaler provides another example of the behavior in one of his papers on the subject:
A former colleague of mine, a professor of finance, prides himself on being a thoroughly rational man. Long ago he adopted a clever strategy to deal with life's misfortunes. At the beginning of each year he establishes a target donation to the local United Way charity. Then, if anything untoward happens to him during the year, for example an undeserved speeding ticket, he simply deducts this loss from the United Way account. He thinks of it as an insurance policy against small annoyances.
When you think about it, this professor is using the same money for both charity and speeding tickets, but in his mind he's created a separate, charitable insurance policy to cover those expenses. It's funny, sure, but it doesn't mean that mental accounting is always bad. In fact, you can use this tendency for good—to take control of your budget and your finances.
Mental accounts aren't always bad
Mental accounting might be irrational, but that doesn't mean it's always a bad thing. As another academic paper on the subject points out, you're probably less likely to raid your investment account to buy luxury goods than your checking account. Bad news, perhaps, for your checking account, but great news if you keep a lot of money in investments.
The key, then, isn't to act purely like a "rational" economist and track every penny of your total net worth all the time—nor is it to let your psychology run wild and divide everything into separate accounts. The key is to find a middle ground that utilizes your psychology for good.
Perhaps the most logical place to deploy mental accounting is, as mentioned, for savings and investments. Dedicating a certain part of your income to these activities protects them from the whims of discretionary spending and can possibly help you avoid dipping into those "special" funds at inappropriate times.
The usefulness of mental accounting
But there are other applications. Because mental accounts offer you the simplicity of categorization, you could also use them to help track your budgeting. Just think: instead of trying to keep your mind wrapped around every penny that goes to groceries, gas, coffees, and clothes, what if you tried to keep your budgeting focused on one or two big mental accounting categories?
My major spending category is food, so the budget I keep on top of at all times is groceries. In other words, I've simplified my budgeting by putting my spending into two mental accounts: one for food and one for everything else (housing and the like doesn't "count" because I only track discretionary spending).
You might have two or even three such categories that you'll want to track, but don't let it get complicated. The idea is to focus on the "account" that you need to use often and to let the other accounts sit there untouched. This works for me because it eliminates the complicated "How much money do I actually have?" dance whenever I go to the grocery store. For all those other purchases—clothes, a new coffee machine -- it's easy to consult the "everything else" budget. But on an everyday basis, there is just the pure freedom of only having to think about the stuff I actually spend money on every day.
All in all, mental accounts don't really make sense: just because the grocery budget goes to zero doesn't mean I'll starve. But they can be useful in helping keep the sacred safe from our spending, and in keeping the spending itself under control.