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Sally was once shopping for a quilted bedspread. She went to a department store and was pleased to find a model she liked on sale. The spreads came in three sizes: double, queen and king. The usual prices for these quilts were $200, $250 and $300 respectively, but during the sale they were all priced at only $150. Sally ended up buying the king-size quilt and was quite pleased with her purchase, though the quilt did hang a bit over the sides of her double bed.
This anecdote is an example of mental accounting (or psychological accounting) a concept first named by Richard Thaler. Mental accounting refers to the way individuals code, categorize, and evaluate events.
How Outcomes are Perceived
Mental accounting captures how outcomes are perceived and experienced, and how decisions are made and subsequently evaluated. This is illustrated by the anecdote above involving the purchase of the quilt.
People mentally frame assets as belonging to either current income, current wealth, or future income.
Another component of mental accounting involves the assignment of activities to specific accounts. Both the sources and uses of funds are labeled in mental accounting systems. People mentally frame assets as belonging to either current income, current wealth, or future income. In reality, since money is fungible (interchangeable), money is money, and shouldn’t be treated differently.
Mental accounting does have a positive effect in that it helps individuals achieve a degree of self-control. For example, by classifying part of your wealth as untouchable (e.g., dedicated to meeting children’s education expenses), you are less likely to use it to meet current expenditures.
Similarly, supermarket shoppers spend less money at the market when paying with cash than with their debit cards (and credit cards), even though both cash and debit cards draw on the same economic resource. In this scenario, knowing about mental accounting may cause you to pay with cash so you may spend less.
Mental Accounting in Investing
Unfortunately, when individuals place each goal and the wealth that will be used to meet each goal in a separate mental account, they may not consider the risk or correlations of the other mental accounts, resulting in portfolios that resemble layered pyramids of assets, as opposed to viewing the portfolio as a whole.
For example, if we were to ignore a large 401(k) account that is currently with your employer when we determine which Intelligent Investing portfolio is best for you, the end result may not be what is best to meet your current, short-term, and long-term needs.
Mental accounting influences asset location policy through focusing on individual goals (children education, living expenses, etc.) from a more rational/optimal look at the portfolio as a whole. In the example of “pyramiding”, the investor is focusing on investments with very low risk (guaranteed) while they could actually reach higher returns at the same level of risk through diversification (considering correlation amongst assets) to possibly reach all goals quicker.
This is one of the reasons why it is important to understand all of our clients’ assets. By looking at all investments as if they are part of the same portfolio, Intelligent Investing can analyze the investments’ correlations and determine a true portfolio allocation.
Read More Here: Mental Accounting, by Richard Thaler