Today I’d like to address the psychological phenomenon called from the world of behavioral finance called Mental Accounting.
As we enter the New Year and everyone begins making their budgets, mental accounting is very likely to pop up. People will subconsciously create different buckets for their money. As a result, their portfolios are not optimized.
Let’s discuss it and see if it’s something that you find yourself subconsciously doing.
Mental Accounting
Mental Accounting is the tendency for people to treat one lump of money different from another lump of money.
Even though money is fungible. A common example is treating your 401(k) differently from your Brokerage portfolio. Sure you might label one account your “retirement account” and the other one your “play account”.
Another example is the tendency for people to separate their money into different buckets. And then use those buckets to target different objectives in their lives. As a result, your money allocation is inefficient.
But in the grander scheme of things, all of that money belongs to you.
In an fully optimized and efficient world, your 401(k) and your Brokerage account are on the same balance sheet. Therefore, for diversification purposes, they should all be considered part of an overarching portfolio that covers your entire life.
We’ll call this your Grand Portfolio.
That is to say, this is the Grand Portfolio that includes your 401(k), your taxable portfolio, your IRAs, your cash, CDs, and money market funds.
There’s no longer such a thing as a “retirement portfolio” and a “play portfolio”.
Your Grand Portfolio
If your perfect allocation is a 60/40 stock/bond portfolio and you currently have a target date fund in your 401(k) that meets that allocation, then you’re optimized. Your Grand Portfolio is where it needs to be.
Now if you decide to go into your Robinhood account and and purchase 100 shares of Apple, your Grand Portfolio has just shifted. You no longer have a 60/40 allocation and this is something most investors miss.
What you see:
- I have a fully diversified retirement account: my 401(k).
- I have 100 shares of Apple in my Robinhood account. Hmm…I’d better diversify this account.
You don’t need to diversify, you’re already diversified in your Grand Portfolio. If anything you may need to purchase bonds to re-allocate back to a 60/40 allocation.
Playing With “House Money” is Mental Accounting
The same can be said with money that you’ve won or gained from gambling and investing.
When someone is doing well at the casino, and they’ve taken their money off the table, they’re now playing with “House money”.
This is a mental accounting bias.
There’s no such thing as “house money”.
People like to say “house money” because it gives the investor a peace of mind knowing that they can’t technically “lose” because it’s not their money.
In reality, it is their money.
If you can use it to pay for bills and put food on the table for your family to eat, then it’s real money.
Mental Accounting Visualized
The average investor may have their personal finances split up into separate buckets with different objectives for each bucket:
- Income earned from salary – disposable money used for immediate expenses
- Emergency Fund – some cash set aside, just in case
- Vacation fund – money put away each money for an excursion
- Education – money set aside for school or for children’s schooling
- 401k – money set aside for retirement
- Individual Brokerage Account – money set aside to YOLO high risk trades
The results of the Mental Account bias leads investors to unnecessarily overweight into assets that may not be optimal for their portfolio.
As explained earlier, if you have a 401(k) that’s invested in the S&P 500 and then you decide to buy Amazon, Google, and Apple in your “play portfolio”, you have unnecessarily created an overweight towards these sectors. These companies are already in your 401(k).
Addressing the Mental Accounting Bias
Fortunately, mental accounting is not something we need to eliminate, just something that should be addressed. Attempting to erase this irrationality from the markets would itself, be irrational.
THERE IS NOTHING WRONG WITH DOING MENTAL ACCOUNTING
The point of this blog post is awareness. Being conscious that you’re doing it so that you’re not going towards extremes.
In reality, people subconsciously split up their money into buckets. It helps them save. It helps them organize. Instead of fighting this human intuition, we can adapt to it.
To address the mental accounting bias, we use Goals-Based planning and investing.
In Goals-Based investing, an investor’s Grand Portfolio is constructed in layers such that each layer contributes to a certain part of their goals. The combination of these layers will meet their Grand Portfolio’s objectives.
Goals-Based Planning
In Goals-Based planning, instead of dividing money into buckets like mental accounting does, the investors’ assets are divided into three layers: Aspirations, Market, and Personal.
Personal
The Personal layer addresses all of the necessities one needs to survive. This includes the most liquid of assets: Cash and Cash equivalents. These ensure that you have food on the table, can make rent payments, debt payments, and monthly bills. As a result, this is the most important layer and hence why it’s the largest layer. It’s also the foundation on which all other layers rest.
Market
The Market layer includes your assets that are exposed to the stock markets. This is your retirement account, your IRAs, your brokerage accounts. This is the middle layer and stands between your needs your wants. As a result, it is the second largest layer.
Aspirations
Your Aspirations layer includes everything else. People want to invest in new businesses, buy real estate, buy cryptocurrencies. The aspirations layer represents the layer with the lowest level of necessity. As a result, it stands at the top of as the smallest layer. Be sure to distinguish between needs and wants.
Mental Accounting is a fairly newer topic of study under the field of Behavioral Finance. Behavioral finance aims to explain the irrationality that investors have with the markets and their finances.
To read more about Behavioral Finance, I recommend the book Thinking, Fast and Slow by Daniel Kahneman. A very good read with lots of experiments and examples.
As described above, people subconsciously use mental accounting all the time. Budgeting is a major source of this bias. Remember that this is not an ugly bias. However, doing it while being unaware can lead to extreme skewness in your Grand Portfolio.
In conclusion, next time you’re budgeting out your accounts, be conscious of the mental accounting bias. Envision your different portfolios from a Grand Portfolio perspective.