Mental Accounting: Be a Financial Vulcan To Live Long & Prosper

Mental accounting is a common financial behavioral error. It can be insidious and feel natural, even though it is illogical and detrimental. I have succumbed to it often and still do. Even Dr. Spock does occasionally – it is a constant inner battle between our human and Vulcan blood. Think you are all Vulcan? Let’s examine some common mental accounting pitfalls and find out.

What is mental accounting?

Mental accounting is subjectively dividing our money into different “accounts” for different purposes. A classic example is having different jars of money for different expenses. That can be a useful budgeting strategy to become conscious of how much you spend and on what. However, it can become a problem if you are using it for saving and investing.

For example, why stuff money into your “Saving for a Vacation” jar when you are carrying a high-interest credit card debt? You are paying 18% interest so that your money can sit in a jar and you can look at it, feel like you are building towards a goal, and get excited when you add money to it. Subjective, illogical, human.

But, I don’t use money jars. That is soooo 21st century.

Ok, some people actually do use mason jars or dresser drawers to divide up their money. However, most now use electronic accounts. These are equivalent in terms of mental accounting. In fact, they may be behaviorally worse in some ways.

We experience “pain” when spending money. It can even be seen on a functional MRI of the brain! Credit cards and electronic transactions elicit less of a pain response than the tactile process of counting out the money. So, the potential danger is even higher when dealing with our electronic accounts.

spending mistakes

All money is the same regardless of its form, how we get it, store it, or spend it.

The technical term for that is fungibility. Breaking from that concept results in the main mental accounting errors. The above example illustrates the effect of form (physical vs electronic). Let’s look at the other common pitfalls.

Mental accounting errors from how we get money:

Found Money

The perception of how easily we obtain money affects how we treat it. For example, if you unexpectedly inherit some money, you are more likely to freely spend it on something frivolous than if you had toiled away for it.

A very common example of this occurs every year with tax returns. Those getting a big refund often feel joy. The logical emotion would be remorse or even embarrassment. Even though they initially worked to earn this money, the temporal separation from that and receiving it weakens the mental connection. They may decide to spend it on something fun instead of rationally allocating it to debt, their TFSA, or even decreasing the amount that they draw from their corporation.

House Money

Another common pitfall similar to “found money” is “house money”. This is part of confusing investing with gambling.

Some people see that their investments are ahead and decide to make more speculative investments than they should. They rationalize this similarly to a gambler betting money from the winnings that they didn’t walk into the saloon with.

If they lose it through speculation, it is still money that they had and is now gone. If, like games of chance, it is a deliberate decision to risk that money for entertainment purposes, then fine. However, I agree with White Coat Investor that “play investing” is an expensive hobby.

Serious Money

I haven’t seen this one talked about much. So, I made up that name. Like the “play money” that someone gambles with, we can treat a “found money” windfall differently based on its size.

For example, if you inherit $20K, you might buy that Harley that you’ve been eyeing. And more disability insurance.

If you inherit a million dollars, that is serious money. That type of windfall may cause one to pause and think carefully about how to best invest it.

All fortunes are built one dollar at a time. Ironically, those getting smaller amounts of money need to be more deliberate with it – but may be less likely to do so.

Mental accounting errors with debt:

Labeling Debt – Credit cards, consumer loans, student debt, mortgages, and margin

Debt is borrowing from our future earnings to spend the money (plus interest) now instead.

We can rack up debt from a variety of sources for a plethora of reasons. It can be packaged in any of the forms mentioned above. We may feel better about some debt, like student debt or a mortgage, because it is borrowing to hopefully build or improve our wealth longer-term.

Consumer debt holds less warm and fuzzy connotations. However, it too could used be to buy something that will improve your productivity. For example, a basic car to drive to facilitate employment. Just be careful of how easy it is to justify spending to ourselves.

It is not the named purpose of debt that matters, but the interest rate paid and expected return in the future from spending the money now.

Spending while in debt is like taking out a loan.

While carrying debt, decisions to spend money rather than pay off the debt is functionally the same as using debt to make the purchase. Re-aligning your thinking to this may help you to make better spending decisions.

Would you take out a loan to go on an expensive vacation? If you spend money from your bank account on the vacation while carrying debt elsewhere, then that is what you are doing. This is not to say that we should delay all gratification to the future. However, we should be conscious about spending wisely.

Serious Debt

Most students in professional training programmes know this one well. Like the serious money mental accounting effect discussed above, size matters. It can be overwhelming to deal with a large debt. It may also seem relatively harmless to add a little to it, here and there, since it is already so big. Humans naturally think in relative terms. Like a tick, debt can numb you with its anesthetic saliva while it bloats and drains your financial and human capital. Grab it by the head and pull it out.

Debt and Investing

Investing using borrowed money is called “leveraged investing”. Leverage can magnify your gains. However, it can also magnify your losses. If an investment goes to zero, then you have lost that and still owe the money.

That kind of increased risk/reward can really play to the emotions that provoke bad investor behavior. This is a critical issue because successfully investing with leverage requires a long-term plan that you adhere to despite the bumps along the way. It is generally not for beginners or those with limited risk tolerance. This is why most people try to pay off debt aggressively before aggressively investing.

The math may favor investing early vs paying debt with our current low interest rates. However, investor behavior influences how the theoretical returns pan out in reality. Plus, one of the main functions of money is to pay for comfort. Counterproductively to that goal, debt can cause a lot of psychological discomfort for some people.

Don’t Be Constrained By Accounts With Names

There are many different accounts that together make up our financial portfolio. Some of these accounts have names like Registered Retirement Savings Plans (RRSPs), Tax-Free Savings Accounts (TFSAs), Registered Education Savings Plans (RESPs). We also have operational accounts like our personal or business bank accounts.

These accounts have special features that support the purpose emphasized by their name. However, these features can also serve other purposes. A spousal RRSP can be used for retirement planning, but also for funding a parental leave, sabbatical, or income-splitting.

Perhaps the best example is the TFSA. While it can be used to “save” for short-term purchases, its greatest powers manifest when it is used as a growth-oriented investment account for the distant future (retirement) or for estate planning.

Don’t think of these accounts in isolation.

Think of them as part of your whole portfolio to make the best use of them.

When planning for our kids’ educational costs, an RESP is only one pot from which we can pay. There is also cash flow and other accounts that we can draw from. Optimally combining an RESP and personal account or an RESP and a corporate account was recently explored on this blog. Students can also benefit from earning money at a student job and/or through scholarships.

We save for retirement using multiple accounts also. If paying a salary, we contribute to the Canada Pension Plan. There are also RRSPs, personal accounts, corporate accounts, and the TFSA. If drawing a low income, then Old Age Security is another source of money.

All of these different accounts have different tax features that give them strengths and drawbacks. Thinking of them together helps us to optimize how they work in our overall portfolio to complement each other synergistically.

When you are married, your finances are mingled.

marriage finances

Mentally accounting where the money comes and goes as individuals in a marriage is especially problematic. Some people struggle with this because they have different values around money and spending habits from their partner.

Choosing the right partner is one of the most important financial decisions of your life. I married my best investment – but like any good investment, I did my “research” first. Frugal wierdos in love is a sure recipe for financial success.

When you get married, everything accrued after that is split 50:50, in the event of divorce. If keeping your finances separate helps to control the spending of a low-earning-high-spending-spouse, that could be financially beneficial. To the other facets of your life – maybe not so much. If it leads to resentment and divorce, that is a monumentally emotional and financially expensive result.

If you function as a financial unit, you can achieve better long-term results.

Why leave one partner with high-interest debt when that expense is hampering your ability to build wealth?

With investing, evenly distributing your assets can make it easier to draw them down in a tax-efficient way later. In the case of a couple with one high-income earner and a low-income earner. The high-income spouse can stuff both TFSAs and pay all living expenses. That way, the low-income spouse can invest excess income in an account attributed to their lightly-taxed hands. In fact, eligible dividends have a zero or even negative effective tax rate for people making $40-50K/yr in many provinces.

If you share finances and don’t fall into the mental accounting trap, but end up getting divorced for whatever reasons. At least you will have more assets to split 50:50.

Sunk Costs

We all make mistakes. When we use mental accounting to separate personal and financial costs, we can make them worse. The key to understanding this is realizing that money is just a medium of exchange.

We exchange time, effort, comfort, and security to make money. In turn, we spend money to get those things back in other ways. It is very easy to mentally separate our financial cost and the cost of our time, effort, comfort, and security. Let me illustrate with a personal example.

Last year, we were camping at Disney Fort Wilderness. Out of a strange sense of obligation (since we enjoy the campground but minimize our time at the parks and restaurants), we went to the all-you-can-eat buffet on the campground. It was a $200 meal for our family.

financial mistakes

Since we spent $200 on this, I wanted to make sure I got my money’s worth. That would be several days worth of food. It took time for the food to settle between helpings and unyielding effort to continue stuffing it down.

The end result was that it cost me more in discomfort. Even with the button on my jeans undone and discretely hidden behind my big cowboy belt-buckle.

The $200 was a sunk cost. I was not going to get that money back regardless of how much I ate. I added to the cost by being illogical and persisting to add to the personal cost via my discomfort.

Personal and financial success are tightly intermingled and require broad thinking to pull off ambitious financial goals.

Ten Tips For Being A Financial Vulcan

Mental accounting is a natural, human tendency. Being aware of this and the common pitfalls can help us to live long and prosper through logical financial decisions. Here are some tips to make your ears pointy:

  1. Feel the pain of spending money. Be aware of the painless nature of electronic money. If you have a spending problem, try using cash.
  2. Don’t lose your own money so that you can get excited when you find it later. For the self-employed, this means estimating your required quarterly income tax installments. Make sure that you don’t underpay (the interest penalties suck), but also don’t grossly overpay.
  3. If you are ahead financially, don’t blow it. If your investments are ahead, remember that they do fluctuate. Stick to your plan and risk tolerance – don’t gamble.
  4. Be deliberate regardless of the size of a windfall or debt. It all adds up.
  5. Classify debt by its cost and the expected benefit instead of its name.
  6. When spending while in debt, consider whether you would take out a loan for indulgences. That is what your are functionally doing.
  7. Paying Debt vs Investing. Investing while in debt is investing with leverage. That increases potential risks. This is best for those with experience and financial reserve to absorb losses.
  8. Think of your total portfolio when considering how to best use the different accounts that constitute it. Don’t compartmentalize based on account names. We use all of our money to achieve our financial goals.
  9. If married, function as a financial unit. You are one, legally, and failing to do so can be expensive: financially and personally.
  10. To err is human. Be a Vulcan and don’t add to it. Don’t compound a sunk financial cost by stubbornly adding personal cost.
mental accounting


  1. Over time I’ve fought off most of the mental traps you’ve described. Reading your list is like a timeline of my past mental mis representations. Probably the most useful item is to consider all assets and liabilities in one picture and make thoughtful decisions from there. Laughed hard with the buffet example. Who hasn’t done that. The 5lb bag of chips at Costco isn’t a deal if you eat them all!

    1. Thanks Phil. I have committed pretty much every sin on the list over time. Even knowing about them, human nature is difficult to overcome. With the 5-pound bag of Costco chips, I also end up consuming a pound of chip dip.

  2. LD, I have never laughed so hard at any of your posts, starting with the Laurier Vulcan and “your’ fMRI and ending with you trying to eat $200 (U.S.!)’s worth of food.

    Not so funny: “princess math” where, if you “save” $200 by buying a $600 skirt for $400, then you’re supposedly allowed to spend that $200 on something else because you were such a frugalista.

    Keep up the excellent work, both on educating us and on keeping us rolling!

  3. Nice tips LD!

    If married, function as a financial unit

    Definitely a key point if married.

    I have noticed many of our family/friends who have separate joint accounts and invest separately from one another. They don’t know what the other spouse is investing in. For me, that’s an odd concept! I think a married couple’s portfolio should be treated as one total portfolio so you know what % stocks/bonds you are investing in as a family. But to each his own.

    1. I hear you on that one, DN. It always surprises me too. Each relationship is unique and different things work for them. However, I personally see financial intermingling as a major trust and co-operation issue. Tax laws encourage it and family law enforces it, but trust and co-operation strike me as being key to any lasting relationship.

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