When we get the money we didn’t expect, we tend to treat it differently from our regular earnings.
This is because of mental accounting, a concept in behavioural economics that explains how we treat money in our minds.
In this article, I’ll explore why we handle unexpected money the way we do and how we can approach it more wisely.
Table of contents
What is mental accounting?
The term mental accounting was introduced by Nobel-winning economist Richard Thaler in 1999.
Through his experiments, he showed that we have an implicit accounting system. We treat cash differently based on how we got it, classifying it into separate ‘accounts’ — even though all money is the same from an economic standpoint.
So, when we receive money out of the blue, we ‘create’ an account for that specific sum. The problem with this account is that we often spend it entirely on things we wouldn’t usually buy because of our unlimited wants.
Consider the following examples.
Found money: Imagine finding a $10 note on the street. It feels like this is ‘free money’, not part of your regular budget. As a result, you’re more likely to spend it on something spontaneous, like a takeaway coffee, rather than adding it to your savings.
Gift money: We often think cash received as a gift is meant for something fun or memorable. Why would you use it to pay off debt, right?
Bonuses: When we receive a bonus at work, it feels like a reward, so it’s often spent on extra holidays or a new laptop.
Inheritance: It’s not unusual for people who inherit money to spend it all quickly and without much thought. This is why many set up trusts — to control the distribution of assets.
As you see, we often make irrational decisions with unexpected income that don’t align with our long-term financial goals.
So, how can we prevent this from happening?
How to avoid mental accounting
One of the most effective strategies for making better financial decisions is to plan ahead.
You’re less likely to make impulsive decisions when you have a plan. Instead, you’ll follow the guidelines you’ve set for yourself.
For example, you can create rules for dealing with unexpected money depending on the amount.
For small amounts, like compensation for delayed flights, your guideline might be to use half on practical things like groceries or household supplies and the other half on something enjoyable.
For larger amounts, such as tax refunds or insurance payouts, you might decide to always allocate one-third to savings, one-third to paying off debt, and one-third to something fun.
And in rare cases of particularly significant amounts, such as an inheritance or a major lottery win, you might create a rule to consult a professional before making any decisions at all.
This way, you’re less likely to spend it all impulsively on frivolous things.
Final thoughts
I hope you’ll recognise this cognitive bias in yourself now. Remember, mental accounting is a theory — not all people make decisions exactly the same in reality.
Still, having a better plan for handling windfalls will help you enjoy those fortunate days even more, knowing you’re also setting yourself up for the future.
And the good news is: you don’t need to wait for an annual bonus to give yourself permission to go on a weekend trip or buy that luxury bag you’ve always wanted. A dollar is a dollar, isn’t it?