Part III in our Wealth Psychology series: Professor Dilip Soman outlines the mental magic that happens when we apply labels to our money — and how it might help you save for your goals.
DILIP SOMAN: Back before we had online banking, some families would use jam jars to allocate what they could spend. You'd cash your paycheck at the end of the week. And then split it up into jars labeled for groceries, car, rent, and anything else. Behavioral scientists call this mental accounting.
Now things are very different. For many of us, our paychecks go directly into our bank accounts. And with automatic payments, we are less likely to notice what comes out. That can be a good thing, though it may also come with some unintended consequences. The reason the jam jar system was effective was because it created a physical barrier between you, your spending, and your savings. You could see the money that was earmarked for expenses, as well as the money you could save or spend. It was also a visual reminder that money in the jar would run out at some point, so you had to adjust your spending accordingly.
Our brains are wired to make financial decisions based on time, context, and money. In this case, it's the psychology of money that's at play. And the labels we give to money can have an effect on what we are willing to do with it. In the case of the jam jars, that money is separated and labeled differently, and only to be used for the things they're labeled for.
Instead of washing out jam jars and asking your employers to pay you in cash, there's everyday ways to help make mental accounting work for you. You might consider opening a separate account that is allocated for your kids' activities, emergencies, your vacation property, or any other goal you're saving for. It's one way to help create a mental barrier between you and your money. Unless, of course, you want to start eating a lot of jam.