How to Stick to Your Budget
By: Mathieu Gouraud
Tags: Money Mindset, Budget, Personal Finance

There is a concept in finance called the time value of money.

The basic idea behind it is that $1 dollar today is worth more than $1 dollar in the future.

This is a generally accepted idea because you can earn more interest the sooner you put it in an interest producing account.

But what if I told you that the same amount of money can have different values even in the present?

This idea seems absurd.

After all money was created because we can all agree upon the fact that it holds the same value for you and your neighbour.

But the irony is that we don’t value money the same way even for ourselves.

Depending on how we earn it and what we want to spend it on, we put different values for the same amount of money.

This idea may well be the missing piece behind why it is so hard to stick to your budget

How to Stick to Your Budget: Mental accounting

Mental Accounting is the idea that we value money subjectively as opposed to objectively. Depending on how we earn it, spend it, and how it makes us feel, we put different values on the same amount of money.

Richard Thaler discovered the concept of mental accounting and introduced it to the public in 1999 in his paper “Mental Accounting Matters”.

It’s important to understand mental accounting because it can lead us to make irrational spending and investing decisions.

It may also well be one of the reasons why it is so hard to stick to your budget,

By understanding it and avoiding its pitfalls, we can use this missing piece to design a better budgeting process, one which makes it easier for ourselves to follow through with.

4 Ways Mental Accounting Happens

Mental Labels

The most common way mental accounting happens is by giving money “mental labels”.

The best way to describe mental labels is by imagining that you have small bank accounts in your brain for different uses.

We have Spending banks accounts for:

Coffee

Eating out

Groceries

Clothes

Etc…

And we have Earning bank accounts for:

Regular income

Work Bonuses

Gifts

Money on the street

This allows us to know where our money is going and coming from, which is a great thing when it comes to tracking our money

But it can also constrain us and make us irrational.

Take the following example:

Let’s say you are taking a walk and you find $50 dollars in the street.

You might have been out for a walk without wanting to spend on anything.But the fact that you found money led you to spend it.

Instead, you could have saved the money. But you didn’t because you did not put as much value on it as if you had truly earned it.

Framing

One other way mental accounting can trick us is through framing.

One study showed that depending on how a problem is framed, we are more likely to make irrational choices.

In the study, participants were given two versions:

A calculator that originally costs $15 is on sale for $10 at another store

A calculator that originally costs $125 is on sale for $120 dollars at another store.

The catch is that you have to drive 20 mins to get the other store.

In the first case, most participants were willing to drive to the other store while in the second case most participants would rather buy the calculator.

The difference is the same but because of the way the questions was framed the participants made different decisions.

Frequency

Frequency is another reason why it’s so hard to stick to your budget.

When you assign budgets to yourself, do you do it over days, weeks, months, years?

On the one hand it might be easier to stick to short term goals such as spending a certain amount on clothes on a monthly basis.

But on the other hand it may not always be practical.

If you need to buy a new suit or a new dress because it doesn’t fit any more, you might go over your monthly clothing budget and feel bad about it.

If you view it over a year you have more leeway and won’t feel bad about making the purchase.

Categorization

How broadly or narrowly we decide to categorize our expenditures can have a huge impact on whether or not we stick to your budget.

Do you have a category for Entertainment in your budget?

Is it further broken down into Restaurants and drinks?

Or maybe just restaurants?

It’s Important to know what we spend money on but it’s not always practical.

A narrow view might make it too hard to follow our budget but having a broad view may keep us from seeing the details and optimize our spending.

Examples of Mental Accounting

Debt vs saving

Some people have a mental account for debt and a mental account for saving for specific goals, such as buying a house.

Although it may seem like a smart thing, this can keep them from paying off their debt sooner and avoiding less interest payments.

Paying down debt as soon as possible may seem like straightforward advice, but a lot of people do not follow this principle because they view saving for a house as too important.

What they fail to realize is that they will have less money available to buy a house if they do not pay off their debt first.

I’m under budget! … But I overspent

Mental accounting can cause us to restrict ourselves in one category while we spend more than we actually need to in another category.

This is a huge think people are missing when coming up with budgeting tips.

We don’t stick to our budget because sometimes we just need things. And then we feel bad about it after.

Sometimes we will eat out more, sometimes we need to treat ourselves to a vacation before anticipated. But our budget does not allow it for this specific item.

But when you look at the bigger picture you realize that you underspent by a mile in your other categories. You could use your underspending in one category to overspend in another category.

Marketing and sales

Yet another classic example of companies and their marketing and sales teams taking advantage of our psychological pitfalls.

Especially on big ticket items, we tend to be more open to spend more money on bonuses and extras.

Marketing salespeople know this so they will frame the extra money as just a small expenditure.

You just bought a $30,000 new car?

“Why don’t you get the leather look seats with it? It’s only 5% more than what you’re already paying, and it’ll feel 10 times more luxurious.”

5% is $1500 dollars more, and you’re not even getting real leather!

But because of the way the salesman framed it, it doesn’t seem expensive. People fall for this all the time.

2 Ways to Stick to Your Budget

I’ve talked about different areas where mental accounting happens, but its biggest impact remains on budgeting.

Budgeting is a bit of a mix between science and art.

My hope is to provide you with some guidelines that will make it easier to draw up your own budgeting process.

Broaden your Categorizations

I mentioned higher up that sometimes you have a better view by looking at your whole financial picture when it comes to expenditures.

Let’s say you overspent on eating out and going for drinks for the month already. Your friend’s birthday is coming up and he or she wants to go to a fancy restaurant to celebrate.

You decide to go but you feel terrible about yourself because you are now in the red for the month and you know you are going to have to restrict yourself for a while before going out to eat again.

But you also did not spend much on other entertaining activities. You didn’t go to the movies this month nor did you go on a weekend getaway. You just didn’t feel like it.

If you had categorized restaurants and drinks in the entertainment category, you would still be way under budget for the month!

My point is not to go all out on eating out at the expense of other activities. My point is that by broadening your spending into a higher category, you have more flexibility.

Some months you will feel like going out to eat more, some months you will feel like going to the movies, some months you will want a weekend getaway every weekend.

Use Budgeting Apps

At this point you might be thinking… I still need to track my spending to see how much I am spending and on what activity.

I totally agree.

In fact I even check this myself. But I don’t obsess over it.

Nowadays, budgeting apps make it sooo easy to see what you are spending on specifically.

I use Mint to see where my money is going. This is the best budgeting app that I have found and it’s completely free.

The feature that I like the most about it is that you can decide how broadly or narrowly you want to analyze your spending:

Take the “Food and Dining” category for example.

If I click on it I can see a more narrow version that includes the below categories

If I want to see how much I spent on restaurants, I can see the details of the transactions below.

But even with those apps, you will still be missing some stuff when budgeting.

Sometimes I pay for friends, sometimes they pay for me and I send an e-transfer to pay them back

What you see on top is not an accurate picture of how much I spent on food. Some transactions are omitted because I paid my friends back and some are overstated because I paid for my friends but they paid me back.

Having somewhat of a picture is better than having no picture at all nonetheless.

And if I see an abnormally large expenditure, I can look into it.

But the bottom line is I don’t obsess about how much I spend for a specific category.

I take a broader look and as long as I spend about what I anticipated to spend for the month, I give myself some liberty.

It’s much less tolling mentally and emotionally.

How Do You Stick to Your Budget?

If you already have a budget but are finding it hard to stick with, I hope that this new perspective makes it easier to stick with.

I am far from perfect when it comes to budgeting for myself so if you have any other tips you would like to share with me please do!