The idea behind mental accounting is that people naturally separate money that has different intents from each other. For some reason, economists consider this a bad idea. From the website Investopedia (emphasis mine): “According to the theory, individuals assign different functions to each asset group, which has an often irrational and detrimental effect on their consumption decisions and other behaviors. “
Investopedia uses the example of saving for a vacation while carrying credit card debt. That’s not the level of mental accounting I’m discussing here. If you are still carrying credit card debt while holding onto a savings account for a vacation, then stop right here. Get that taken care of first.
Now, I’m going to focus on two types of mental accounting: one for the day to day management of a household, and one for longer term investments.
Dismiss the Criticism
First things first though. Much of the work on mental accounting clutches to very basic concepts. Richard Thaler, another U of Chicago guy, uses an example of a $10 movie ticket. He asked people two questions. If you lost your ticket after you purchased it, would you buy another? And, if you lost your $10 bill on the way over, would you still buy a ticket? Only 46% of respondents would buy another ticket in the first example, while 88% would still buy a ticket in the second example. According to Thaler, people view the cost of a movie as $10, so if they lost the ticket, that movie would cost $20, whereas if they lost the $10 bill, it would still only cost $10 to see the movie.
When economists perform studies like these, they really seem to have only a marginal understanding of humans. The assumption is that humans are logical, rational actors. Clearly, they have never been to a football game. Logic and rationale are rarely seen at a Packers-Bears game. Personal finance is personal. Any tricks that can be used to increase our odds of success should be used.
The criticism behind mental accounting is that money is fungible, meaning that a dollar can be used for anything that a dollar can be used for. Except that that is not always the case. A basic example is money locked away in retirement accounts, which can only be used when you turn 59 and ½ (with a few exceptions). Alternatively, money needed to pay property taxes should not be used to go out to a Friday night movie with Richard Thaler (although I’m sure he’s a nice guy). Hence, using mental accounting by putting money into money buckets can actually be a perfectly logical strategy.
Day to Day Management
Using mental accounting to build out a system of money buckets can help save time and build discipline. The use of mental accounting is fairly ingrained in us, starting with our first paycheck. That first paycheck was probably broken down into rent, groceries, beer money, etc. Money bucketing is intuitive and natural. Designing a smart mental accounting system from the get-go will produce better outcomes. Below is an outline of how we manage our money on a day to day and month to month basis.
All of our money flows into our joint checking account. The source does not matter. The vast majority of our earned income comes from my job at the endowment. My wife, on the other hand, has a very, very part-time paid job while spending most of her time caring for the kids and handling pretty much everything else in our lives. Life is logistics, after all.
I’ve never thought of my paycheck as my money, because it’s not. My wife and I had a conversation early on in our marriage about our plans for the future. The bottom line was that I was in a career path that led to a far more efficient earned income than she was in. She, on the other hand, is far better at handling all of the family and life commitments that we deal with continuously. She works just as hard (probably harder) than I do on a day to day basis. I just get paid really well to do it, whereas our society has determined that she should not. Unfair? Absolutely, and also just the way the world works. So we work within it.
We also each have a personal checking account in which we give ourselves an equal allowance each month. While family money is family money, we both recognize the benefit of having some of our own money that we don’t have to answer to the other about. If she wants Starbucks every day, or I want to buy expensive power tools, then so be it. And since it’s an equal amount, there is no resentment or animosity. I know of couples that have their paychecks go to their personal checking accounts and contribute, proportionally based on income, into a joint account. However, the higher earner will still have a higher level of spendable income in this arrangement. That seems like a recipe for animosity.
For a few of our basics, we even take out cash monthly. Groceries, gas, and fun money all have a budgeted line item and we take out cash to put in envelopes. We began doing this over a decade ago. By now, our income and discipline are likely high enough that we could stop doing this and still stay on budget. But for us, this seems like a good habit that is not worth changing. This is also a great learning tool for our children, as it helps them associate handing over real money to buy things as opposed to just using a “magic” plastic card.
Non-Recurring Expense Account
Perhaps the most important mental accounting we do is with our Non-Recurring Expenses account (or, NRE account for short). The best description for our NRE account is just a prepaid expense account. Here we get to our pretty extreme use of money buckets. We use one money market account, but have a spreadsheet with separate categories for things like vacation, property taxes, home repairs, and insurance. Each month we net a set monthly inflow against any expenses paid during the previous month, and just transfer the difference. Our account looks something like this:
Money is fungible. But insurance and property taxes have to be paid once or twice a year, regardless of whether I lose a $10 bill on the way to the movies. Our NRE account is part of our emergency waterfall, but outside of an emergency, we won’t touch the money until we need it for the specific purpose. The goal of this account is not to build a large balance, rather it’s to manage the large cash flow events that occur on a somewhat regular basis but can kill a budget. I find comfort in knowing that when the property tax bill shows up in April and October, the money will be there to pay it.
Our family’s emergency fund is where Richard Thaler may have the biggest issue with our mental accounting, and here he’s likely correct. The size of the fund has fluctuated over the years, but for over 15 years we have never had to tap it. Factor on top of that the fact that we have two paid off homes with untapped lines of credit that we could use, and the argument against the emergency fund becomes even greater.
All of the above are fair criticisms, but for us, these do not rise high enough to warrant getting rid of the emergency fund. I have an innate fear of not being able to provide for my family. This, for me, is a greater motivation to become financially independent than pure freedom (which I highly value). Quite frankly, I suspect that if I do ever fully retire early and become FIREd, our emergency fund will become even larger. This makes little sense, but remember that personal finance is personal. If your decision is only a matter of degree of personal conservatism, than by all means, make the decision you are most comfortable with.
Investment Account Bucketing
Investment account bucketing is a different animal entirely from the day to day cash flow management. Whereas day to day management is really just putting certain amounts of cash in certain buckets meant for certain things, investment account bucketing actually impacts investment decisions. Our investment accounts break down into three major categories: Long term (retirement and post-high school kid’s money), F-you money, and get rich money.
Long Term Dollars
Our long term dollars consist of tax advantaged retirement accounts and money for our kids to start out their lives after high school. Both of these have a fairly long term horizon, and the potential for current needs is near zero. Hence, in both cases, we can actually be fairly aggressive with these investments (all while minimizing drawdown risk as much as possible!). Retirement accounts cannot be fully touched until age 59 ½, which for us is still over 20 years away. And money for our kids won’t be used for over 10 years yet, so while a little less aggressive than our retirement money, is still fairly aggressively invested.
One of the big “drawbacks” of retirement accounts is the tax advantaged nature of the accounts. Retirement accounts would be the perfect location from a tax perspective for high income earning assets (bonds, real estate, high dividend stocks), but many of these also have lower expected returns. From a perspective of financial independence, it’s backwards to the desired set-up. As discussed below, you actually want to put higher income earning assets in your F-You account, but there are negative tax advantages to that.
Also note that we do not call money for our children a college fund. We anticipate making a certain level of gift to our children over a course of a few years post high school. College is by far the most likely use of that gift, but we do not want to shut down paths that our kids could pursue. If they’d like to use the funds to start a business or buy a house with no mortgage, those would be acceptable options as well. So while we do have 529 accounts for each of our kids, we also have money in a separate taxable brokerage account in our name that will be used for these gifts if they turn out to be non-college. If not, we have an extra account with money that can be used for anything.
This account is the big enchilada, and the one I spend the most time building. If you are unfamiliar with the concept of FIRE (financially independent, retired early), or F-You money in general, there are a plethora of high quality blogs out there. There’s also a phenomenal scene in the movie The Gambler with John Goodman and Marky Mark.
The goal of this account is to be able to replace your ongoing basic expenses without drawing down the principal. Included in those expenses should be expected longer term repairs and replacement of things like houses and cars. Hence, we like the use of the NRE account, because we recognize and put money away monthly for those non-recurring expenses. Our monthly expenses are in the neighborhood of $4,000-$5,000. Using a long term safe withdrawal rate of 2.5%-3% would lead us to need about $2,000,000.
The investments and ongoing maintenance of this account will be discussed at length in this blog. The goal is to balance out conservation of capital with income growth. It’s all about minimizing drawdown risk, since you’ll potentially be drawing on this account regularly. Remember, this is your fortress, your moat, and your standing army all in one.
Taxes are also a primary concern here. To some extent, you needn’t worry about taxes if this is your only source of income. Chances are high that your tax rate will be very small if you’re only drawing $50,000-$60,000 per year. But given that this account will need to be in a taxable account, it is something that will be in the forefront of our investing decisions.
Get Rich Money
If you have appropriately funded (or are funding) your F-You account, have maxed out your retirement account contributions, have set aside money for the kids, and still have money left over, this is the place for it. This is the place for your potential 10x investments.
The combination of the F-You account and the Get Rich account is the perfect barbell. You’ve got your solid base in the F-You account, now go out and strike it big. If you like venture capital investing, this is the place for it. Maybe you want to invest in your own company. Or maybe you can leverage the heck out of the account and buy a value-added real estate project (just make sure to use non-recourse debt!). You can do any number of things with this account, because you can afford to lose it. Stack the odds in your favor, but with the solid base of the F-You money, take risks. You don’t become a $100 million family by being sheepish.
Where to be Careful
Mental accounting does have one substantial drawback, and that is the source of funds. In particular, unexpected money can actually be a big drawback. People who lack discipline may see that money as extra spending money, because they already have a plan and are following it, so why not live a little? Alternately, you could use that money to supercharge your accounts.
We take a middle road. Depending on the size of the found money, we split it between spending and investing. My annual bonus, while never guaranteed, is generally reasonably assured of being received each year. Since we live off of my salary only, this is essentially found money. However, we practice a combination of discipline and fun spending. We take 75-80% of the bonus and put it away (right now, in the F-You account as we’re still building that). The remaining 20-25% can be spent. For us, spending this money means allocating extra funds to our NRE account in things like vacation or home upgrades that will be spent later in the year.
Mental accounting gets a bad rap, but it shouldn’t. It is perfectly reasonable to have separate buckets of money for separate goals. In fact, it actually makes it easier to manage the day to day cash flow problems and to invest in the future. Focus early on building a good system and then execute the plan.
Keep building my friends.