Using the 'Bucket Mentality' to Your Advantage
Cognitive biases can be useful
Mental accounting, more commonly called the “bucket mentality,” is a cognitive and behavioral bias that most of us naturally adopt. Coined by Richard Thaler, it describes the tendency to mentally sort our money into separate buckets and treat it differently depending on its source, intended use, or label.
It’s why we’re more willing to blow a bonus than a regular paycheck on a splurge, use a tax refund to pay off debt we’d otherwise ignore, and keep our hands off a Roth IRA for decades while regularly raiding and replenishing a savings account.
It’s also why we assign different time horizons, investment allocations and withdrawal plans to various accounts and income streams.
Why is Mental Accounting Bad?
This is technically sub-optimal compared to viewing your portfolio and budget holistically, and it can lead to “irrational” decisions. There is no real difference between $20 you found on the ground and $20 that you worked an hour to earn. But they feel different, and you’re likely to treat them differently. That’s cognitive bias.
It’s really hard to escape mental accounting; it feels natural and intuitive to get more excited about found money than your paycheck and to do “something special” with an inheritance compared to a retirement account you spent years building.
This may sound fairly harmless, but mental accounting can be detrimental in every stage of financial planning. Here are a few common examples:
Illogical Balance Sheet
It can provoke the urge to do irrational things like hold onto high interest credit card debt while keeping low yielding cash in savings. You may think you’re more sophisticated than that, but do you have a mortgage and also own bonds? Then you’re falling prey to it too.
Inflexible Savings
It can encourage us to be too rigid when needs change and flexibility would be more appropriate. Refusing to dip into a vacation savings account in an emergency or contributing to 529 plans at the expense of an underfunded retirement are common examples.
Suboptimal Investing
Keeping a “safe” portfolio here, some “fun money” there, and an aggressive or concentrated holding from an inheritance or employer stock award. This makes maintaining an appropriate overall allocation or rebalancing properly unlikely. Keeping cash savings on top of a balanced portfolio also creates an unnecessary cash drag and a more conservative portfolio than you intended.
Financial & Marital Division
Keeping separate accounts, goals, investments and budget responsibilities has become more common in modern marriages. While understandable, it’s irrational and causes unnecessary friction and inefficiency (both relational and financial) when you treat one financial legal entity as if it is fragmented.
How Can Mental Accounting Be Good?
Rather than try to avoid mental accounting and become the robotic optimizers economists assume we should be, we can use it to our advantage. When harnessed intentionally, the bucket mentality can be an effective tool to meet certain financial goals.
Pay off Debt
As Dave Ramsay has preached for decades, the rational approach to paying off debt is not usually the most effective. (As he points out, if you were being rational you wouldn’t have racked up the debt in the first place.)
Research supports his “snowball method” which entails paying off debt from smallest balance to largest - not by highest interest rate to lowest. The motivational high from knocking out a few debts quickly creates momentum - and ultimately more success - compared to the mathematically optimal strategy.
Save & Invest More
The bucket mentality works well to encourage saving, especially if you automate it. “Set it and forget it” along with labeling accounts specifically for “retirement” can create a powerful system for accumulating wealth. Throw in some tax incentives, and it’s why 401ks and IRAs are so good at getting us to trap accumulate money in them and leave it alone forever until we reach our goals.
In addition, dividing up your “savings” into sub-savings goals can aid budgeting and help people save more effectively for irregular expenses like travel, car replacement, and home renovations.
Withstand Uncertainty and Volatility
This is where inefficient, boring cash comes in. No matter where you are in your financial journey (unless you’re paying off high interest debt), having a cash bucket is imperative. There will be huge market losses, job changes, emergencies. There may be divorces, injuries, deaths. Having cash is a psychological safety net that too many of us go without.
The amount can vary depending on the stability of your income and level of fixed costs. I like having 2 years of expenses in cash during transitions or retirement. It keeps my hands off my portfolio and enables me to drift back to sleep if the existential alarms go off at 3am. If you don’t feel safe, you won’t ever feel wealthy.
Retire Early
Retiring early is a mental challenge when you view your portfolio rationally as one big pot that may have to last for, say, 50 years. In that case, breaking your assets into separate buckets can be helpful for envisioning the timeline.
In my case the buckets look like:
40s - Alternative assets and rental properties
50s - Taxable brokerage account
60s - Traditional IRA
70s - Roth IRA
80s and beyond - whatever is left, social security, possible inheritance
I may not actually drain those specific assets in those particular decades, but thinking about it that way helped me pull the trigger and stop accumulating just for the sake of “more.”
Many “coastFIRE” investors do this when they stop contributing to front-loaded retirement accounts once the math says they are on track. Then the problem simply becomes getting to age 59.5 with a combination of earnings or other assets.
Spend & Give More
We spend most of our lives using the bucket mentality to save, and it can become ingrained. As we’ve all heard, it can be very difficult for many investors to flip the bias toward investing on its head and actually start tapping their savings.
In theory, once you’ve hit your savings targets you should feel free to spend guilt free. This is the mechanism behind the old “pay yourself first” advice. In practice, checking a financial goal off as “done” never really feels complete. The goalposts move, the risks expand at suspiciously the same rate as our net worth, and the impulse to save more and spend less never really goes away.
Enter mental accounting to save us from interminable gratification deferral. It can become a handy way to give tight-fisted investors permission to spend more than they otherwise might. Here are some ways it can work:
Create literal spending buckets.
Just as you had various savings buckets during accumulation, it may feel better if your bills are paid from one account and discretionary items come from another. Spouses may quibble less if they have their own fun money buckets (especially if one of them - probably the one reading this - tends toward the controlling tightwad side of things). Once a year you or your financial advisor can refill the buckets by rebalancing and transferring cash. Then your goal simply becomes draining those suckers!
Embrace Required Minimum Distributions.
Treat them like a legal requirement to have a little fun and blow some money! I discuss this in depth in my last post. You can implement the RMD concept early and across all your assets as a way to prod yourself to (safely) boost spending above your Safe Withdrawal Rate.
Devote income streams to specific goals.
If you have a variety of income streams, allocating them to various purposes can help you spend. Maybe social security covers your bills, the pension is for fun, quarterly royalty checks get tithed, and annual capital gains distributions go to travel.
Create new income streams.
Rationally we should look at a portfolio as a whole, prioritize total return above yield, and create cash flow by selling holdings as necessary and realizing capital gains. All you need is a couple of index funds for a cheap, efficient, high performing retirement portfolio. But psychologically, income is much easier to spend. This is why retirees tend to love:
Rental property - the management could become a hassle as you age, but you can outsource that.
Dividend stocks - These typically underperform the broader market, but the tradeoff might be worth it if it makes you comfortable actually spending more of your money.
Annuities - not my favorite asset, but they are preferable to not spending your money at all if you have a lot of anxiety around selling assets. There may be a place for them for some investors, particularly those unable to manage or understand their investment portfolios.
Notes receivable - my mom lent me money years ago to buy rental property. I’ve offered to pay her back in full, but she loves the regular payments. Hard money loans, seller financed real estate, and other personal loans are options.
Bond or CD ladders - A 3 to 10 year ladder of maturing bonds or CDs can ease financial anxiety and automatically replenish cash each year.
Give appreciated stock.
Most of us find it really hard to realize capital gains just to meet our spending or giving goals. Transferring shares of stock instead of cash can make it mentally easier to give, whether it’s to your kids or your favorite charity.
Use Net Worth Targets.
Calculating “income” in retirement can become arbitrary. Cash flow? Taxable income? AGI? Do gifts or inheritances count? What about reinvested dividends or loan payments?
Set spending and giving targets as a percentage of net worth (or portfolio balance). Perhaps you give away 3% annually, or spend 1% on travel. This works best when your fixed costs are a fraction of your wealth and if most of your spending is discretionary.
Aim to keep net worth under a maximum level. Very wealthy folks might use the estate tax exemption which currently sits at $15 million per person, but I’ve had clients set more modest limits. When and if their portfolios swell above that level, they give away the excess or make big purchases.
If you tend toward over-saving or are stuck in One More Year Syndrome, the key is to think of your money buckets as things that must be emptied. The goal becomes trying to come up with new ways to spend and give it away according to your values.
Try to act as if your money is “use it or lose it.” Because in fact - it kind of is.
I help people get organized and use wealth to design a life that feels secure and aligned. A former Wall Street banker and CERTIFIED FINANCIAL PLANNER™, I act as an unbiased advocate without selling products or managing investments directly. To learn more, visit my website.
DISCLAIMER: I love writing about the personal, emotional, and practical sides of money, but please remember that my Substack is strictly for educational and coaching purposes. The insights shared here are general in nature and do not constitute specific investment, tax, or legal advice. While I am a CFP® certificant, reading this does not create an official advisory relationship, and any comments or likes should not be interpreted as client testimonials. For personalized investment advice, please consult a registered financial professional.