Behavioral Finance – Mental Accounting
Monday, November 30th, 2009 by Cass Chappell, CFP®
In my experience, Mental Accounting is by far the most common bias exhibited by investors. It can also do the most harm to an otherwise well conceived financial plan.
Basically, it works like this: Investors assign different assets to different “accounts” in their minds. Gain and loss is typically looked at separately. The decision to buy and sell is rarely based on the effect it will have on the overall portfolio. Instead, this decision is based solely on its impact to that “account”. In effect, the investor has created silos for each investment they hold.
This bias is to blame when an investor hangs on to losing investments. If they sell, that “account” will have realized a loss….something we KNOW that investors despise. The opportunity to sell the loser and redeploy those assets with the hope of finding a winner is lost by the urge to avoid going “into the red” with that “account”.
Investors who mentally account may sell winning investments too soon. Eager to “chalk up a win”, an investor may sell an investment with recent success (even though that success MAY continue). To an investor swept up in mental accounting, success is defined by “wins” and “losses”.
Spending decisions can become clouded. Consider the situation where someone finances a car at a high interest rate instead of paying with the ample cash in a savings account. To deplete that account would be devastating as compared to paying finance charges…..in the mind of a mental accountant. Even though, if she paid cash, that person could replenish the savings account (with interest) by figuratively making the car payment to herself.
“What’s the formula for successfully overcoming this bias?”
It is very difficult. We are all guilty of this bias in some way.
The easiest way is to constantly consider how financial and investment decisions impact your personal balance sheet. Make your “mental account” bigger. Don’t look at each investment as an account. Instead, view all of your investment assets (CD’s, IRA, 401(k), checking account, brokerage account, college savings, gifts from Granny) as ONE account. And……..try, as hard as you can, to remove emotion from the decision.
