Playing with the house’s money? Unexpected cash sometimes triggers frivolous spending

While investing and financial planning seem like aspects of life that should be fairly black-and-white, the reality is that we are human and thus our behaviors and emotions can have a notable impact on our financial futures.

A whole cottage industry has been created around this topic. It’s known as behavioral finance, which is sort of a blending of psychology and investments. While research on behavioral finance from individuals such as Daniel Kahneman and Richard Thaler is legion, it’s instructive to focus on a notably impactful subtopic underlying behavioral finance known as “mental accounting.”

Mental accounting occurs when individuals mentally separate their money into different buckets of usage. Sometimes this separation can be driven by the source of the money itself.

In particular, people are notoriously frivolous with money that comes in that may not be part of their normal salary or wages. This could include tax refunds, annual bonuses and inheritances.

When money outside the norm like that comes in, it can be easy to go out and buy that new sports car or visit the fancy, expensive restaurant downtown because there is the perception that you are “playing with the house’s money.”

While I absolutely encourage individuals to spend money on things they enjoy, they should be mindful of the impact it might have on their financial well-being. If, for example, paying down expensive credit card debt or putting it toward investments that may speed up retirement may make more sense, the more spend-thrift decisions should be postponed.

From a pure investment perspective, mental accounting happens when investors separate their money into categories such as retirement money, play money, safe money, the college fund, the house fund, etc.

Let’s focus on “play money” to start.

Sometimes investors will have a taxable account alongside of their retirement plan (e.g. 401(k), IRA, etc.). Many investors will build a long-term asset allocation inside of their retirement plan that lines up with their long-term goals and risk tolerance.

However, that very same investor might treat his taxable account as a place to make speculative investments in hot technology and biotech stocks. While it’s unlikely the investor has two separate risk tolerances, that’s exactly how he’s investing.

In regard to safety accounts, or emergency funds as they are often called, there is nothing wrong with having a little dry powder in case anything in life goes awry. A common rule of thumb is to keep six months’ worth of salary in cash for this very reason.

Where this can become problematic is when a long-term investor puts too much of his money away in the safety fund. Cash tends to be a low-returning asset and inflation can eat away at a portfolio that is too heavily exposed.

Thus, when an emergency fund reaches the right amount, a long-term investor should consider placing any excess into investments that may help put him in a better position to reach his investing goals.

While it can be very challenging for those who practice mental accounting with their investments to get their arms around, the best advice is to look at all your individual accounts and consider them part of your overall asset allocation and investment plan.

In other words, try hard to not express different risk tolerances across different account types.

In regard to cash usage, money is money is money. Regardless of where it comes from or where it is housed, considerations for its use must be made at every turn in life. For each decision forthcoming, consider how that decision will impact the state of your long-term financial well-being.

Doing so will put you in a much better position to meet your long-term goals.

Ryan Hodapp is Chartered Financial Analyst and a member of the Financial Planning Association of Greater Kansas City. He is Director, Investment & Advisory Sales for Waddell & Reed, Inc., an unintegrated entity of LPL Financial. In his role, he helps advisors associated with Waddell & Reed navigate the complex process of constructing portfolios designed to weather the uncertainty of the capital markets.