The Hidden Trap in Your Finances: How Mental Accounting Can Distort Financial Decisions (and How to Fix It)
Have you ever splurged on a luxurious item because you found a ‘great deal’? Or are you more relaxed spending on your credit card than spending your physical cash?
This is called "mental accounting", a common bias that affects how we view our money, leading to different spending and saving habits.
Welcome to 10 Years Wealthier With Miriam! In this blog, we'll dive into how mental accounting can hold you back from financial success and show you how a financial adviser can help. Pay close attention, as this information will help you understand how to make better financial decisions!
The value of an investment with St. James's Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested.
What is Mental Accounting?
Think of Mental accounting as having separate mental compartments for your money. We tend to categorise our money based on its source or intended use, even though it all holds the same value. It's' like having a monthly budget and organising your spending meticulously (which is a good thing) but then having excess income at the end of the month (disposable income) which you just 'waste' because it doesn't form part of the 'said' budget.
Imagine receiving a hefty Tax rebate, which you did not expect to receive, you might be inclined to spend it impulsively, it's technically free money… right?'
Or you might have a monthly gym membership, which is costing you a fortune, and you haven't visited in a long while. However, you refuse to cancel because you will go tomorrow and it is an investment into your future health (unfortunately, tomorrow never seems to arrive). In reality, you are wasting your hard-earned money - is it time to revisit that budget?
Thinking in these ways can lead to numerous poor financial choices and connects to the concept of behavioural finance, which emphasises that emotions and biases often cloud our financial judgement.
Key Concepts In Behavioural Psychology: How do these concepts relate to the Stock Market?
While mental accounting can influence investor behaviour, leading to both holding onto losing stocks and panic selling, it can also present opportunities. Savvy investors understand that market downturns can be ideal times to increase investments. Investors that have a long-term perspective should understand that lower pricing is normal, and won't necessarily stay lower in the long run. This gives the potential for growth although there is no guarantee that the price will rise. If it does this could take a significant amount of time and you cannot predict by how much. In the worst case it could drop even lower.
The Smart Investor's Secret: Diversification
Imagine two investors, Amy and Dan, each with £5,000. Dan is convinced a specific tech company is a sure thing and puts all his money there (Dan has an overconfidence bias).
Amy decides to invest in the tech company too, however, she spreads the risk and diversifies, investing in a selection of global equities, fixed income, and property as well.
What Happens?
Scenario 1: Tech Boom: Dan is overjoyed (a little smug even) His £5,000 could multiply.
Scenario 2: Tech Bust: The company flops. Dan is distraught, he loses a lot, maybe everything.
Amy is less affected by either scenario, as her portfolio is more stable, whatever the outcome of the tech company, her smartly diversified portfolio is not just replying on that one company.
Amy may not get Dan's potential (short-term) windfall, but she also avoids the risk of losing everything.
Be like Amy, invest in a diversified portfolio, for the long term.
Gentle reminder; when there is so much noise around ‘a great investment’, it is likely already too late, you've probably missed it.
The Role of Diversification: Slow and Steady Wins the Race
While Bitcoin’s dramatic price swings capture headlines, they also underscore the importance of diversification. Instead of focusing on the best-performing individual asset (like Bitcoin or a single stock), a diversified portfolio spreads risk across multiple uncorrelated investments. For example:
● Remember Dan? Well, he has now recovered (emotionally) from his investment loss and is ready to invest again. This time, he just ‘knows’ Bitcoin is the best thing since sliced bread, everyone knows it, right? He decides to put all his savings into Bitcoin!
● Amy, on the other hand, remains focused on her long-term investment strategy in a diversified portfolio.
What Happens?
● In a bull market (financial markets where prices are rising), Dan might see significant gains, but in a bear market (financial markets where prices are falling), he could, once again, lose everything
● Amy, once again, experiences overall growth. Even if one investment underperforms, others can help balance it out.
Grasping these behaviours is essential in behavioural finance, a field that explores why investors often make decisions that contradict the traditional economic theory. As we've seen, a simple cognitive bias can lead people to spend a tax rebate without thinking. Likewise, many investors chase high-performing stocks without considering their fundamentals. This behaviour can create unsustainable market bubbles that eventually burst, causing significant losses. Therefore, understanding these biases and managing your investments with care is crucial.
As the saying goes, “Don’t put all your eggs in one basket.” Long-term investing is about patience and strategy, not chasing gains.
Let's consider how Mental Accounting may affect busy professionals
Professionals, for example, are more likely to have demanding schedules, a complex workload, and possibly high income that comes with higher taxes. With all these responsibilities, they may not have the headspace to think about the huge amount of tax they are paying, causing them to miss financial opportunities and more tax-efficient investments.
Being time-poor can indirectly cause people to neglect their financial planning and consequently make financial decisions without carefully considering the long-term consequences,
Let's look at Solicitors as an example
Income Variability
Income for solicitors can fluctuate significantly. The legal profession, like many others, experiences variations in income due to factors such as economic cycles, competition within the field, and the nature of client-based work. This income variability can present challenges for long-term financial planning and may require careful budgeting and financial management strategies.
With their demanding work schedules, legal professionals may struggle to prioritise their financial education, which can result in less informed investment decisions, potentially impacting their long-term financial well-being.
Work-Life Balance Issues
The demanding nature of legal work can make it difficult for solicitors to maintain a healthy work-life balance. This imbalance might negatively impact personal well-being which may lead to increased spending on leisure activities as a way to cope with work-related stress.
The Story of Sarah Thompson: The Financial Adviser Solution
Sarah’s story is a fictional example based on common financial challenges faced by high-earning professionals.
Sarah, a 38-year-old solicitor, was thriving professionally but struggling financially. Despite a substantial £120,000 annual income, she had nothing to show for it, and in addition, was overwhelmed by debt. The combination of mortgage payments, household bills, childcare expenses, and credit card debt created a financial strain that weighed heavily on her. Sarah’s monthly expenses totalled £5,500, and her outstanding credit card debt was £30,000. She realised that she needed help managing her finances.
- Income: £120,000 per year
- Monthly Expenses: £5,500 (including mortgage, childcare, and living costs)
- Debt: £30,000 in credit card debt
- Savings: £10,000 in a savings account
Meeting with the Financial Planner: Steps to Financial Clarity
Feeling overwhelmed and anxious about her finances, Sarah decided to consult a financial adviser. After a thorough assessment, her financial adviser created a personalised plan that focused on budgeting, debt management, and savings strategies. This involved identifying non-essential expenses to reduce spending without impacting her quality of life while prioritising the repayment of high-interest debt. Additionally, a new emergency fund was established, to reach £16,500, to protect Sarah from unexpected financial difficulties. Her comprehensive financial plan also incorporated investment and retirement planning.
In just six months, Sarah's financial situation improved dramatically. She had reduced her credit card debt by half, from £30,000 to £15,000, built a £5,000 emergency fund, and decreased her monthly expenses by 15%, saving an additional £800 each month. Sarah's story shows that even high-earning professionals can encounter financial difficulties, but seeking professional guidance can lead to more financial security and peace of mind.
Financial advisers offer immense value to busy professionals like Sarah by providing personalised financial strategies, continuous support, and expert guidance that can enhance their overall financial well-being. Here are some key benefits of working with a financial adviser:
How a Financial Planner Can Help
Mental accounting might seem harmless, but it can sabotage your financial goals. Recognising your biases is crucial for making more sound financial choices. If you're struggling with mental accounting, consider speaking with a financial adviser to overcome it and help secure your financial future.
Remember, even the most experienced professionals can fall prey to cognitive biases. To learn more about managing your finances confidently and effectively, stay tuned for future episodes of my blog for expert guidance on your economic well-being.
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The value of an investment with St. James's Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested. Past performance is not indicative of future performance.
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Although the content of the article was correct at the time of writing, the accuracy of the information should not be relied upon, as it may have been subject to subsequent tax, legislative or event changes.
