Money jars and mental gymnastics: What are you really saving money for?

Having written about the different aspects of money for more than two decades now, people often tend to talk to me about what they think about it, in particular about saving it. And one thing that I clearly see is that individuals like saving money for a certain goal. For their retirement years. For the education and weddings of their children. For a holiday. For their health expenses. To save taxes. And so on.

Now, this is a very natural human thing to do, given that we tend to place money in different mental accounts. Richard Thaler, a Nobel Prize-winning economist, who coined the term, defines it as “the inclination to categorise and treat money differently depending on where it comes from, where it is kept, and how it is spent”.

Now, of course, this is an extreme example of the mental accounting of money, but it does explain the concept very clearly: In the minds of human beings money is not always fungible. But that's not really the case. While in the minds of people, money comes with labels, actual money really has no labels. In fact, the money in Hoffman’s different jars could have easily been used to pay for food and he didn’t really need to borrow money from Hackman.

And this has its implications. As Thaler writes: “Wealth, too, is often separated into various mental accounts…This can lead to the odd behaviour of simultaneously borrowing at a high rate of interest and saving at a low rate, for example by keeping money in a savings account…while maintaining an outstanding balance on a credit card that charges interest at more than 20% per year.”

Now, for a trained personal finance mind this might seem like a rather silly example, but believe me I have come across many such examples over the years. People have more than enough money in their bank accounts and are continuing to pay a high rate of interest on their credit card debt. Even those who are short of money don’t understand that it may be possible to take on a personal loan at a lower rate of interest and repay the credit card debt.

Now, I started this piece with how people think about saving money. They need a goal. And a goal is basically nothing but a mental account. It gives people a purpose to save money for something that is important to them. And that’s a good thing.

But at the same time it can end up confusing some as well, especially when there is only so much money that can be saved or if the individual hasn’t really started saving money up until late in life or even without that. This leads to a situation where people often wonder: Should we save money for our retirement? Or health emergencies? Or for the education and weddings of our children? Now, these are important questions to ask.

So, money should be saved, because money should be saved. So, do that SIP. Keep topping up that recurring deposit account. Or that public provident fund account. Now, of course, you may not end up saving all the money you might need to meet the requirements totally, but some money is better than no money. Also, a sense of balance is necessary. Don’t end up overblowing money on children. There needs to be some money in the bank for the retirement years as well. And that’s the right way to think about money and savings, without really putting it into different mental accounts.