The power of mental accounting and partitioning to increase savings
Mental accounting “is the set of cognitive operations used by individuals and households to organise, evaluate, and keep track of financial activities” (Thaler, 1999). Different to traditional accounting with spreadsheets, calculations and accuracy, this is about the mental shortcuts we use to group and manage our personal finances.
A defining element of mental accounting is grouping funds into different categories, to help us make faster decisions about our money. When we categorise sources of income differently, it influences the way in which we spend that money. For instance we are more likely to spend “windfall” earnings (bonus, salary increase, unexpected rebates) than regular income, and are more likely to spend windfalls on luxury items than essential goods.
Why it works: Partitioning to budget effectively and control spending
Segregating or earmarking funds can help to simplify financial planning by limiting the complexity of choices that households face, improving cognitive efficiency by narrowing the set of choices to consider. Setting spending rules upfront also helps to encourage financial discipline and keep spending under control. For example, earmarking rent or grocery money that cannot be spent on going out, or savings for a home deposit that cannot be spent on holidays.
The rate of consumption can be decreased by physically partitioning resources into smaller units, for example cakes wrapped individually or money divided into several envelopes. When a resource is divided into smaller units, consumers encounter additional decision points — a psychological hurdle encouraging them to stop and think. Do I really want another slice of cake?
In the olden days, people used envelopes or jars to allot cash to different budget categories to control household spending. Now, fintech and mobile banking apps are replacing envelopes, facilitating mental accounting through spend categorisation, budget limits and multiple savings goals.
Australian neobank Up automatically categorises transactions to help users get an overview of their spending. Spending insights are delivered monthly and available in realtime, including comparisons against average spend in each category compared to the last three months. Users can recategorise and add tags to transactions, and also see how much they spend at different shops or brands over time.
Qapital, with Chief Behavioural Economist Dan Ariely, designed a weekly Spending Sweet Spot to allow users to customise a budget that fits their spending habits and income, in order to maximise savings potential.
Why it works: Partitioning to increase savings
Similarly, money we’ve specifically earmarked as savings is more likely to stay as savings, if we’ve partitioned it away from our spend money. Dipping into funds we’ve already allocated to savings creates a mental friction point where we should hopefully be encouraged to stop and think.
In this vein, fintechs have played on this psychological hurdle to crate positive friction to encourage more deliberate stopping and thinking.
To remove temptation to dip into allocated savings, UK neobank Monzo allows customers to lock a savings pot for a set amount of time to help you save. If you try to withdraw money from a locked pot, Monzo will remind you that you can’t until the date you set. You’ll can add money to your pot as normal, but you won’t be able to withdraw any. You can also hide pots you don’t want to see every day.
Moven app users can protect their savings by locking funds away until they hit a target amount. When the milestone is reached, they can access their savings by tapping the app interface three times to simulate ‘breaking the glass’ — a neat device to make the user think before spending their hard earned savings. Moven powers the mobile apps of Westpac NZ and TD Bank in Canada amongst others.
When doesn’t it work?
By its nature, mental accounting and partitioning is not a perfect system.
If categorisations are unclear (e.g. groceries for a party — categorised as food or entertainment?) this can lead to a breakdown of trust in one’s own system which can tempt people to break their own rules. In addition, expenses that don’t neatly fit into assigned categories may end up not being accounted for, which in turn can lead to overspending.
Studies have shown that too complex or granular partitioning can lead to people losing sight of the bigger picture; broader bracketing of funds allowing people to consider a more complete set of information.
Studies have also found that whilst having savings goals is more effective in encouraging long-term savings behaviour than not having goals, that a single goal is better than multiple. Why? Because multiple goals may compete with each other and evoke trade-offs between them, which puts people in a more deliberative mindset than a single goal which encourages a more implemental mindset.
Soman & Zhao (2011) conducted a field study in a small town in India, where 83 households agreed to participate in a financial literacy program. One group were told to save more because it would help finance their children’s education. The other group were given two additional savings goals: to save more so they could also finance their healthcare needs and also to provide a nest egg for when they retire. Participants in a control group were given no specific goals.
To facilitate the partitioning of savings, half of all households were provided with a thick paper envelope to set aside the cash they wanted to designate as savings. The savings goal was further reinforced on the envelope: in the single-goal condition, the envelope had a small picture of a child, and in the multiple-goal condition, there were three pictures (a child, a hospital, and an old couple).
The results showed that a single goal led to higher savings rate over six months than multiple goals. Having any goal/s (single or multiple) was more effective than no specific goals, and partitioning using envelopes (whether single or multiple goals) was more effective than not.
How many is too many?
The previous study focused on long-term savings only, so when you include spending and managing your whole financial life, what’s the optimum number of partitions (or envelopes, jars, buckets etc.)?
In the “JARS Money Management System”, T. Harv Eker proposes 6 er…jars(!) for:
1. Necessities (55%) — rent, food, bills
2. Long-term (10%) — savings for spending (holidays, big purchases)
3. Play (10%) — going out, fun
4. Education (10%) — coaching, mentoring, books
5. Financial freedom (10%) — investing
6. Give (5%) — charity
A favourite amongst Aussies, Barefoot Investor Scott Pape also proposes the power of 6 (buckets this time), split across:
1. Blow Bucket: Daily expenses (60%) — rent, food, bills
2. Blow Bucket: Splurge (10%) — weekly fun spend
3. Blow Bucket: Fire extinguisher (20%) — put out fires, pay off debts and bigger bills — then move this into Mojo, then Grow
4. Blow Bucket: Smile (10%) — long-term savings for big fun stuff (holidays, cars, furniture)
5. Mojo Bucket — emergency savings (separate bank, out of sight, minimum $2,000 up to 6 months pay, then lock and move the rest into Grow)
6. Grow Bucket — long-term investments for the future
Looking globally at neobanks and fintechs that offer multiple sub-accounts, it’s clear that there is no standard!
Note the many terms used to describe sub-accounts: spaces, pots, goals, savers, vaults (and I’ve also heard buckets, envelopes, pools, jars). Also note that some neobanks and fintechs provide sub-accounts for both spend and save types whilst others only allow that option for savings.
There will always be people who want more flexibility and that do get more motivated by their own more complex system of multiple goals — just look at the people crying out for more pots on Monzo’s community forum! But to encourage the optimum amount of budget management and saving amongst the most people possible, we can harness the power of defaults (the behavioural scientist’s most powerful weapon) and conclude that 3–6 spend and save sub-accounts as a default option might be optimal, with one long-term saving goal encouraged over multiple, with the flexibility to add more for those who get motivated by more granular control.
To summarise, there is a stack of evidence to show that partitioning is better than not partitioning, and that setting goals leads to a higher rate of savings. Findings also suggest that a single savings goal is more effective than multiple, but that the key reason for the effect of the single goal is the implementation intention it activates. So whatever we use sub-accounts for, the golden rule should be to create a bias to action. Anything that introduces mental hurdles to the saving behaviour we intend to create (introducing trade-off between goals, unclear or too complex categories) should be eliminated.
Sources
Thaler (1999), Mental Accounting Matters.
Thaler (1985), Mental Accounting and Consumer Choice.
Soman & Zhao (2011), The Fewer the Better: Number of Goals and Savings Behaviour.
Zhang & Sussman (2018), Perspectives on mental accounting: An exploration of budgeting and investing.
Soman & Cheema (2011), Earmarking and Partitioning: Increasing Saving by Low-Income Households.
Colby & Chapman (2013), Savings, subgoals and reference points.
