Irrational Accounting

This is a blog in a series I titled “Mental Money Mistakes.”

What are mental money mistakes? They’re subtle errors in judgement—basic oversights and miscalculations. As a rule, they tend to be subtle and easy to miss. I’m not talking about big mistakes like taking on a bunch of debt, spending more than you can afford, or being too risky with your investments. No, these are the kinds of mistakes just about anyone can make, even if you’re intelligent and hard-working.

If you’re like most people, you get a paycheck every other Friday. A lot of it probably goes to covering your expenses. Another portion goes into your savings. Whatever’s left over gets used for recreation.

Now imagine that you find a $100 bill under the couch cushions, get a nice Christmas bonus from your employer, or receive a hefty tax refund. What do you do with that money?

Many people tend to look at these unplanned-for windfalls as “free money.” As a result, they spend the money on luxury items, vacations, or even on a quick gambling jaunt to Vegas. To put it simply, they use the money on short-term wants instead of long-term goals.

It’s perfectly understandable why people want to do this, and every once in a while, it’s probably okay. But when you do it too often—when you treat a $100 bill differently depending on where it came from—you are guilty of “irrational accounting.”

Irrational accounting is a mental mistake because it means you are making financial decisions based off emotion and impulse rather than logic and planning. Done too often, it can become a potentially damning habit.

Remember, mental money mistakes are a problem because they can keep you from getting ahead financially. In this case, while it might be fun to spend “free money” on luxuries, it’s also counterproductive to reaching your long-term goals.

Taking that money and either saving it or investing it can dramatically shorten your timetable to retirement (or whatever else is most important to you).

Of course, none of this means you shouldn’t ever buy that new gadget or enjoy a fun trip. What it does mean is that you should pay for those things the same way you do everything else—by saving and budgeting your normal income.

In this day and age, both our government and many private businesses are guilty of irrational accounting. We see the damage this causes every time we turn on the news. It’s important that we as individuals avoid making the same mistake. No matter where our money comes from— whether from our regular paycheck or underneath the couch cushions—it’s critical that we treat it the same. Always make financial decisions based off logic and planning rather than emotion and impulse. Always make long-term goals your highest priority whenever possible. This is the path to “getting ahead” financially.

And of course, once you’re ahead, well ... the sky’s the limit!

Keep an eye out for future blogs, where we’ll discuss another Mental Money Mistake... and learn why too little risk can be just as bad as too much.