Why Investors Do The Crazy Things They Do – Concept 2 Mental Accounting

imagesIn my last article I discussed a concept called behavioral finance. It’s a relatively new field that tries to combine behavioral psychology theory and economics and finance to explain why people make irrational financial decisions.

In the last article we discussed Anchoring. A tendency to attach our thoughts to a reference point like a stock’s highest price. This article will cover Mental Accounting. And no, it’s not mind math.

Concept 2. Mental Accounting
Mental accounting is the tendency for you to separate your money into different accounts based on subjective criteria, such as the source of the money or the goal for the money. I do this too, but for good reason. I believe that separating, say cash reserves from investments, is a good idea. I also have a separate account to pay taxes and save for holiday spending. I even advise my clients to do this.

Another aspect of mental accounting is people treating money differently depending on the source. Do you treat “found money” from unexpected sources differently than that of your regular paycheck? I do. Just got a refund check from my health insurer stating they overcharged! (Yes I agree, what are the odds?) Did I spend it on fun stuff? You bet.

Mental accounting bias also occurs in investing. I’ve seen investors separate their investments based on inheritance form a parent or favorite brother or aunt. Where it really gets weird is having safe investments and also speculative investments in separated accounts. The mental accounting bias occurs when the investor things that if there is a drop in the speculative investments it won’t affect the entire portfolio. The fallacy of thought is that in spite of all the work and cost  to do this, net worth will not be any different than if they were one portfolio.

How to Avoid Mental Accounting
Remember all money is the same. It has the same value regardless of its location or purpose. “Found” money has the same value as the money you earned on your paycheck. In addition, separating accounts based on risk is fruitless. Base the investments risk on your time horizon. The reality is that the investments will go up and down regardless of how they are separated.

The next articles will cover Confirmation and Hindsight Biases, The Gambler’s Fallacy, Herd Behavior and Overconfidence just to name a few. Interesting stuff, so stay tuned. If you want this series of articles delivered to you automatically, click here for a free subscription and have them in your email inbox every Friday morning!