Opinion: Beware the pitfalls of mental accounting

Opinion: Beware the pitfalls of mental accounting

Opinion: Beware the pitfalls of mental accounting

Nick Armet, investment commentator for Fidelity explains why your clients segregate money, and the possible dangers of doing so:

Not all money is equal. The evidence from the field of behavioural finance is that we do not treat money consistently. Instead, we segregate money into distinct wallets and apply different rules to them. This ability to create differentiation between the sources and intended uses of money is the central issue at the heart of mental accounting.

The concept of mental accounting was first described by the behavioural economist Richard Thaler in 1980. Mental accounting has implications for behaviour as ‘accounts’ are treated as non-fungible and our willingness to spend out of each account is different. Logically, money should be interchangeable regardless of its origin or intended use.

The mental accounting bias is a significant problem in investing. For example, many investors divide their investments into separate accounts (mental and physical). Consider a simple split between a safe investment portfolio and a speculative portfolio. The problem with this separation is that net wealth would be unchanged if the investor held one portfolio. But by separating the two, the investor could be tempted to cut winners in the speculative account to top up the safe account to some pre-established psychological level.

We know that selling winners and holding losers is a common investing pitfall; and having too many accounts of individual investments can exacerbate the issue. This problem is one reason that helps to explain the popularity of mutual funds; they are efficient from a mental accounting standpoint since individual losses and gains on stocks are aggregated into one overall account return.

When mental accounting combines with loss aversion and the natural short-sightedness of investors, it may help to explain the persistence of the equity risk premium. Thaler and Benartzi argue that so strong and continuous is the impulse for investors to see their accounts “in the black” that it encourages them into safer, less volatile assets (like bonds) and it also encourages over-trading as accounts are regularly reviewed. This allows them to see their strategies working over relatively short time spans (most investments are analysed on a yearly basis), and avoid the short-term pain of loss aversion associated with higher volatility assets (like equities) that typically outperform over the longer term. In short, if enough investors are myopic and loss-averse mental accounters, then it may help to explain why more rational and patient investors enjoy the benefit of excess returns in the long run.

The solution to mental accounting is to remember that money is fungible regardless of its origins or intended use. Investors should be wary of considering individual accounts and investments in isolation from each other. Money levels in accounts should not be determined by arbitrary rules of thumb; rather all accounts should be reviewed against a backdrop of changing investment conditions. For example, money in assets once considered safe such as long duration bonds may now be at risk due to recovering economic conditions and the prospect of rising interest rates. By taking a holistic and long term view of your investments, where every dollar is a dollar and is working most effectively for long term gain, investors can avoid the worst pitfalls of mental accounting.