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Show notes

This episode is about mental accounting - the process of putting our money into categories in our heads and deciding what to do with it based on those categories.

This is a big topic, so we’re starting with how we think differently about money that comes to us from different sources and how that affects whether we save or spend that money and on what.

The science behind this is in Richard Thaler’s paper Mental Accounting Matters (opens as pdf).

Two key points:

1. We act as if money from different sources (wages, bonuses, gifts, savings interest, winnings etc) is somehow different money and should be used in different ways. This is strange because the whole point of money is that £1 is £1 is £1 no matter who gave it to you and why.

2. When we receive some money we will often think about that money as a single lump instead of splitting it up. Then we will use the whole lump sum for one thing instead of putting a bit towards one use and another bit towards something else.

Example

If Alex and Martha each get given £50 each for our birthdays we would probably treat this differently from if either of us got a tax rebate of £50. Martha would probably spend a tax rebate on something useful like new work shoes and Alex would hold onto it in case HMRC changed their minds and want it back.

When it comes to birthday money, Alex may put the whole £50 into savings and Martha may spend £28 on cocktails, £16 on a taxi and £6 on a kebab on the way home. It might be smarter for Martha to take the bus home and eat some toast when she gets there at a saving of about £20, but in her head she’s put all her £50 into a pot marked “fun”, so it all goes on fun. Alex might be happier if she spent £20 on a treat and saved the other £30, but she’s put it all into a mental pot marked “savings” so it all goes into savings.

(N.B. overall Martha’s still spending more and Alex is still saving more and that’s up to us. The point is we’re not just going with our default pattern for the whole amount, we’re thinking about whether a different split would suit us better.)

Our tip:

People often take an easy-come-easy-go attitude to unexpected sums of money and end up spending them on a whole load of nothing much. To avoid doing this, make a plan for what you’d do with some surprise cash, a Windfall Wishlist if you like. Think about small sums like an extra £10, through to £50, £100, £300, £500, £1,000 and up as large as you like.

Martha keeps her wishlist as a Pinterest board.

Remember, a bigger windfall could still be spent on several smaller things, and all or part of any windfall can go into savings or investments.

You can also treat this as a list of savings goals (but you don’t have to).