Understanding Mental Accounting Bias For Better Investing

Introduction

Over the next few months we will be posting a series of articles called the Investor Behavior Series. Our goal is to provide helpful content that can be a source of information regarding behaviors that hurt investors when it comes to their investment goals. As most of us know (and are in complete agreement with)–investment success and financial peace comes by following a well thought out financial plan. This financial plan is a road map that can guide us in good markets and bad markets. More importantly, it is a beacon that we can follow so that we have the highest probability of investment success. A financial road map is not a guarantee of investment and financial success since ultimately what matters is whether or not we follow it with disciplined purpose while being able to ignore the machinations of the market.

Our first topic in the Investor Behavior Series is Mental Accounting.

Mental accounting is a term used to describe the way that we treat money differently due to the source of where it came from. Simply put, mental accounting bias is the practice of assigning money into different categories in order to make it easier to save and spend. It's not necessarily a bad thing but can lead us astray when it comes to investing.

…and the reality is that we all do it.

What is Mental Accounting Bias?

Mental accounting is a way of thinking about money that isn’t based on logic. It's a way of thinking about money that is based on emotion and what we want to do with our hard-earned money.

The definition of mental accounting regarding investing was developed by economist Richard Thaler. Thaler defines mental accounting as a behavior of investors who “classify funds differently and [...] are prone to irrational decision-making in their spending and investment behavior.

In short, mental accounting is when we treat money differently depending on where it came from (our job) or how it was earned (by selling or winning something).

One of the ways to avoid mental accounting is to have a well thought out financial road map and plan. But even then, you could still be prone to mental accounting if you are not careful. Mental accounting is something that many people struggle with when trying to save money for investing because they don't know where their money came from or what category it falls into.

Mental Accounting Bias is common among the investors.

Mental Accounting Bias is a cognitive bias that affects the way we think about money. We tend to separate our money into different accounts, such as “fun money” or “savings” and treat these accounts differently. This leads us to make poor decisions with regards to our investments because we are ignoring the effect of compound interest and other benefits of diversification.

Mental accounting can create irrational behaviors in investors causing detrimental decision making when it comes to an overall financial investing and saving strategy. For example, many investors will over-fund a savings account while carrying high balances on credit cards with high interest. To overcome mental accounting bias it is helpful for investors to realize that money is fungible and should be allocated across all of their accounts, whether it is their investing account, savings account, or their checking account.

Professor Thaler offers an example of how mental accounting impacts an investor’s bias regarding their portfolio. Thaler writes: “An investor owns two stocks: one with a paper gain, the other with a paper loss. The investor needs to raise cash and must sell one of the stocks. Mental accounting is biased toward selling the winner even though selling the loser is usually the rational decision, due to tax loss benefits as well as the fact that the losing stock is a weaker investment. The pain of realizing a loss is too much for the investor to bear, so the investor sells the winner to avoid that pain. This is the loss aversion effect that can lead investors astray with their decisions.” (Source: Investopedia, Richard Thaler)

Mental accounting is one form of cognitive dissonance – where people feel uncomfortable when they act in ways that contradict their beliefs or values (like saving for retirement while also spending).

Investors treat money differently depending on the source of where it came.

One of the biggest differences between mental accounting and actual accounting is that investors treat money differently. Some types of accounts are treated as “special” or “separate” from other sources of income, even though they are all part of their total assets under management.

For example, investors will often spend money from a retirement account before they spend money from a paycheck because it feels like a different kind of investment.

In addition to treating types of investments differently, people also tend to treat different amounts within each type differently depending on where those amounts came from.

For example: Investors are more likely to spend money from a paycheck before they spend money from a bonus because getting paid for work feels like an earned reward rather than an unexpected gain like winning at the casino does.

How to avoid mental accounting.

One of the first and most simple steps is to raise your cognition by becoming aware of the mental accounting bias. This will allow you to see that money is fungible and is to be used and allocated among all of the various financial accounts.

Secondly, you can use a budget to keep track of your money. Budgets are not meant to be burdensome or something to loathe (this is why many avoid budgeting) but a helpful tool to track where the money is going and how it is being spent.

As we have stated in previous posts and articles, a financial road map and plan can help investors overcome mental accounting. A financial plan can help you quantify all of your dollars, how they are to be allocated, where the gaps and opportunities are, and how the plan can be implemented with clarity and precision.

Conclusion

In summary, mental accounting is a natural part of life and investors make decisions based on how they categorize their money. The issue arises when you treat your investments differently than other sources of income because you are more likely to invest in something that doesn't align with your long-term goals.

Follow a financial plan and road map so you can keep an eye on the big picture so that your investment decisions are smart decisions and are aligned with an actual formal financial plan.

For more information about mental accounting bias or to find out how you can implement a financial road map and plan, contact us here.