(Drawing: M.C. Escher)

We recently sat down with a business owner who runs a local studio. She’s been in business for several years so when she asked us to take a look at her finances and investments, we were excited about the opportunity to help.

What we learned surprised us.

She had been paying herself roughly $150,000 per year in salary, had saved $50,000 towards her son’s college education BUT HAD $90,000 IN CREDIT CARD DEBT.

We asked, “Have you considered paying off the high interest credit card with the money in the college savings fund or perhaps as a smaller step, moving your monthly auto savings from the college fund to pay down the credit card?” She said she hadn’t really thought about that option because, “they’re for two different purposes – the credit cards were for the business, with a credit card processing companies and the college savings are for my son.”

We sought a different approach, “How about paying yourself less in salary so that the company retains more earnings and you don’t have to float the business on credit cards?” Something held her back from doing this too as she responded, “I don’t want to take a pay cut.”

Interestingly, she viewed her salary differently from the business’ income and on the expense side, she saw the credit cards as totally separate from the money she put away for her son’s college education.

Think you wouldn’t do something like that? Here’s a mental exercise – the more honest your answer, the more you’ll learn about yourself.

Would you go to the other store?

Imagine that you go to a store to buy a new comforter which sells for $100. At the store, you discover that the same comforter is on sale for $50 at a branch that is 5 blocks away. Do you go to the other store to get the lower price?

Now imagine that you go to a store to buy a new mattress and bed frame set which sells for $4000. At the store, you discover that the same mattress and bed frame set are on sale for $3950 at a branch that is 5 blocks away. Do you go to the other store to get the lower price?

Studies tell us that most people answer “yes” to the first question and “no” to the second, even though they offer the same situation: save $50 by going to a nearby store. Why would people do this if everyone acts out of self-interest and has “rational expectations”?

Irrational Expectations

In part, the discrepancy is ignored because of the difficulty in constructing economic theories and models when you remove the assumption of “rational expectations”.

Common sense tells us that people don’t always act rationally but this basic premise is largely ignored in Economics.

However, a pair of psychologists named Amos Tversky and Daniel Kahneman scientifically validated that human judgment and decisions are indeed not fully rational. They merged psychology and economics and developed a new field of thought known as “Behavioral Economics”.

So if people aren’t always rational, then what’s really going on?

Mental Accounting

In behavioral economics, “mental accounting” attempts to explain why people value one dollar differently than another dollar based on where it comes from or where it’s being spent. By devaluing a dollar, there is a tendency to waste it.

Another mental accounting example we see all the time is how people tend to spend their tax refunds. It’s as if it’s “found money” so it gets spent on vacations, house remodeling and other large expenditures. If tax refunds were viewed as deferred income, people would put more of it directly into savings.

Here’s the good news: there’s a positive side to mental accounting. Instead of trying to rid yourself of this behavior, here’s how you can embrace it.

Remember the old school days when people saved money in different envelopes marked “Vacation” or “Charity” or “Gifts”? You can take that same concept and setup different accounts marked for different purposes and automate your savings into each. Here’s an example:

This way, you know exactly how much you can spend on vacation and not tap into money that’s meant for a rainy day (for example). Each mental account has its own bank account.

The caveat to this, and the lesson for the business owner, is that establishing different buckets of money is only done after bad debt has been paid off (excludes mortgage, car and student loans). The high interest rates must immediately be dealt with and only then can you work towards saving money for different purposes.

Once you have your accounts established, it’s time to figure out how much to put into each.

This is something we solve for clients through a process we call “Cash Flow Optimization”. The outcome of which is a detailed plan and implementation that integrates your psychology with making the best financial decisions for you.

Some questions to think about:

  • Do you make a lot of money but feel you should be saving more?
  • Are you more likely to splurge with your tax refund than with savings?
  • Is the right amount going into the right buckets for you to reach your goals?
  • If you had someone to set everything up for you and keep you from making mistakes, would that be worth exploring?

The fact that most people do some form of psychological gymnastics on themselves is what we’re most interested in solving.

It’s not just about running numbers and creating financial plans – it’s about understanding what’s holding you back and helping you get through those barriers.

You might already have a psychological barrier in asking for help – perhaps you think it’s a long and complicated process or that you don’t have time to deal right now.

You can do this in small steps or big ones, quickly or at your own pace. What’s important is to take action today.

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What are some good or bad ways you’ve mentally accounted? Specifics examples are helpful so please leave your comments below.