Are Emergency Funds a Bad Idea?
Here's what the research says about using "mental accounting" to manage money
The best financial advice meets two essential criteria:
It helps you reach your goal
It’s simple enough that you’ll actually follow through on it
In the Financial Bull$hit series, I am reviewing popular advice to help you figure out which financial advice you see online is worth following and which you should ignore. When I started this series, I had two groups of people in mind:
TikTok stars shilling financial scams and misinformation
Popular personal finance “gurus” who have gotten rich from giving objectively terrible advice to their readers
Once I started digging into the research, it became clear that there is a third group of people whose advice is less helpful than I once thought: Economists.
While the Finfluncers and personal finance gurus often lack any deep knowledge of the topics they preach about, economists have the opposite problem; they are extremely knowledgeable about managing money and risk, but they view decisions about money as a math problem to be solved rather than an issue of human psychology.
Today, I’ll show you why economic models don’t always yield the best financial advice by explaining why according to economic theory, you don’t need an emergency fund.
Mental accounting and segregating your money
Mental accounting refers to how people organize their financial lives by organizing savings, investments, and spending into different categories, each serving a different purpose.
Often these different categories are spending into separate accounts.
Emergency fund
Retirement fund
Vacation fund
House repair fund
Car repair fund
Kids education fund
Accounts to cover healthcare costs
These are typical examples of using mental accounting to segregate our money from one big pile in our checking account into smaller piles each earmarked for a specific purpose.
There are many names for this, like “sinking funds” or “the envelope system.” Some people even keep money in different jars where the money is set aside for a specific purpose. These are all variations of mental accounting.
Mental accounting is popular because people are better able to make sense of big complex tasks by breaking them into smaller, simpler categories.1 Having different pots of money earmarked for different categories of spending simplifies the decision-making process.
Can you afford a $3,000 vacation to Jamaica?
That question is straightforward for someone who has a vacation fund.
Do they have $3,000 in their vacation fund?
If yes, they can afford the trip.
If not, they’ll have to find a cheaper vacation plan or keep saving.
For someone without a vacation fund, it’s more complicated. I have $3,000 in cash, but what happens if my car breaks down or my furnace dies after I use that money for my vacation?
Mental accounting simplifies our financial lives.
Throughout this series, you’ll notice a recurring theme: The primary role of popular financial advice is that it simplifies complex decisions. People crave simple solutions, and those who cater to that need become popular in the personal finance space.
A personal finance writer's eternal struggle is finding the balance between accuracy and simplicity. The more you simplify a complex problem, the more details you ignore.
The question for any popular financial advice is whether it’s been “oversimplified,” have so many details been ignored that the author has completely sacrificed accuracy for simplicity?
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What economists think about mental accounting
One of the central principles in economics is that money is “fungible,” which means any dollar can be substituted for another.
Pure rational economic theory would suggest mental accounts are useless because they are something we create in our minds. Nothing is stopping you from draining your vacation fund to buy a new TV or pursue an investment opportunity.
So, according to economists, the idea of an emergency fund—a categorized pot of money with a specific purpose—should not exist because all that matters is how much money you have. Categorizing your money should have no impact on financial decision-making.
This is another example of economic theory that works in a model but is entirely disconnected from human psychology.
In the real world, mental accounting matters.
Past research from Richard Thaler has shown that mental accounting does influence financial decision-making, like the amount and timing of specific purchases.2
Budgeting= mental accounting
Creating a personal budget is definitionally an exercise in mental accounting.
When you create a budget, you are earmarking a certain amount of your income for specific categories such as housing, food, transportation, and entertainment.
Most people create further subcategories with rules about how much to spend on specific items. If you budget $800 for “food,” you might spend $500 on groceries and $300 on eating out.
Other people (myself included) don’t use traditional budgets but use mental accounting to set up specific pots of money to fund future purchases. I don’t have a formal written budget, but I have automatic transfers to various accounts such as my emergency fund, car fund, house fund, retirement fund, child savings, vacations, and investments.
So, yes, mental accounting is a very real thing and plays a major role in how people manage their money.
But we still have an important question to answer; does the use of mental accounts help or hurt your finances?
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Benefits of using mental accounting
First, as I already mentioned, mental accounting can help simplify financial decision-making.
I can’t overstate how important this is.
As I have written in the past, the number of financial products offered to regular people has exploded over the past several decades. From credit cards to cryptocurrency, there is an ever-growing number of financial products being shoved down our throats on a daily basis making it impossible to keep up.
Categorizing your spending and savings helps us cut through all the noise and make tangible progress on our financial goals. If you have automatic monthly payments going to your emergency fund, mortgage, retirement, and kids’ education, you’re already ahead of most people.
Second, mental accounting can eliminate the need for “financial self-control,” especially when money is formally segregated into different accounts using automated transfers.
Research has shown that people with high self-control spend less and save more money. A meta-analysis of 29 research papers on financial self-control revealed that the most effective way to increase financial self-control is to use proactive strategies which focus on what you can do to avoid tempting situations to overspend in the future.3
Automatically transferring money from your checking account to a separate account with a specific purpose is a proactive strategy to resist overspending. If I transfer $500 from my checking account to an emergency fund every payday, that is $500 that won’t be spent on impulse buys and splurges.
A 2011 study found that people who segregate money from their checking account and earmark it for specific uses (like an emergency fund) helps people save more money.4
Now let’s talk about some potential pitfalls of being too reliant on mental accounting.
Mental accounting + flexibility= good financial outcomes
The #1 rule about mental accounting and segregating funds earmarked for specific uses is that you must be flexible.
It’s difficult to estimate how much you will need to spend on each category in the future—especially for spending that is infrequent or far away in the future.
You might save $200 per month into a house repair fund, but it’s difficult to know if that is the right amount of money until you discover your roof is leaking.
Here’s a situation where you need to think like an economist and look at your money as fungible. Let’s say you’ve been segregating your funds as follows.
Checking account: $1,000
House repair fund: $1,200
Car repair fund: $600
Vacation Fund: $500
Emergency fund: $1,000
If it costs $3,000 to repair the leaky roof, this is not something you should delay because you only have $1,200 in your house repair fund—you need to take the other $1,800 from your other accounts.
That might sound obvious, but you’d be shocked at how emotionally attached people can be to their savings. A 2016 study found that people are more likely to take on high-interest debt to pay for an emergency expense (like a leaky roof) to preserve their current savings. 5 As crazy as it sounds, many people would rather put $3,000 on a credit card to repair their roof than use the cash they have sitting in their savings accounts.
So, is the use of mental accounting and earmarking money for specific purposes financial Bull$hit?
No!
The economic model is wrong on this one.
Segregating money through “sinking funds,” “envelopes,” or whatever term you want to use can help increase your savings and financial discipline.
Just make sure you are flexible and do not get emotionally attached to your specific pots of money.
Read past entries in the Calling Financial Bull$hit series here and consider becoming a paid subscriber to unlock the full archive of posts.
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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.
Henderson, P. W., & Peterson, R. A. (1992). Mental accounting and categorization. Organizational Behavior and Human Decision Processes, 51(1), 92–117. https://doi.org/10.1016/0749-5978(92)90006-s
Thaler, R. H. (1999). Mental accounting matters. Journal of Behavioral Decision Making, 12(3), 183–206. https://doi.org/3.0.co;2-f">10.1002/(sici)1099-0771(199909)12:3<183::aid-bdm318>3.0.co;2-f
Davydenko, M., Kolbuszewska, M., & Peetz, J. (2021). A meta-analysis of financial self-control strategies: Comparing empirical findings with online media and lay person perspectives on what helps individuals curb spending and start saving. PLOS ONE, 16(7), e0253938. https://doi.org/10.1371/journal.pone.0253938
Soman, D., & Cheema, A. (2011). Earmarking and Partitioning: Increasing Saving by Low-Income Households. Journal of Marketing Research, 48(SPL), S14–S22. https://doi.org/10.1509/jmkr.48.spl.s14
Sussman, A. B., & O’Brien, R. L. (2016). Knowing When to Spend: Unintended Financial Consequences of Earmarking to Encourage Savings. Journal of Marketing Research, 53(5), 790–803. https://doi.org/10.1509/jmr.14.0455
one of the few emails i open
i want an emergency fund to cover 6 months of expenses in case my partner and i can’t work. but again we often will take loans from the accounts when we have overspent then set up automated payments to pay it back. talk about mental gymnastics