Understanding Mental Accounting

When it comes to managing money, we typically segregate our funds into distinct categories, each with its own specific rules, purposes, and limitations. For example, we typically segregate our monies into different categories; some go to a savings account, while others are transferred to our investment portfolios and finally to paying our bills. Despite the salary being a single sum of money, our minds will treat each category separately, which may lead to irrational financial decisions.

Mental Accounting Implications on Consumer Choices

A study done by famous American Behavioral Economist Richard Thaler will bring some insight into how biased our minds can be when our money is compartmentalized.

One example given in the study was when MR. S, who admires a $125 sweater at the department store, declines to buy it, feeling that it is too extravagant. Later that month, he receives the same sweater from his wife as a birthday present. He is very happy. But both he and his wife have only joint bank accounts. The key is noting that MR. S would have felt otherwise if he had bought the sweater initially, despite the same result in spending.

Mental accounting is also prominent in allocating our funds across various investments, especially regarding risk perception. Risk is often defined as volatility when it comes to investing, while volatility refers to the rate of change in asset prices.

Unveiling Biased Risk Perception

Imagine that, as an investor, you have divided your investment portfolio into three mental accounts: Retirement savings, short-term goals, and speculative investments. Suppose a significant downturn happens in the market, and you find that your speculative investments are declining. You might be hesitant to sell because you view these losses as confined to that mental account.

As a matter of fact, you might even invest more money into the speculative account, hoping to recover your losses by averaging down, even though this decision is driven by a psychological reluctance to realize the loss rather than a rational assessment of the investment’s potential.

Furthermore, a segmented view of risk will lead you to make inconsistent choices. You could be extremely cautious with your short-term goals account while adopting a much more aggressive approach within your speculative investments account. This practice will disregard the overall risk exposure of your entire portfolio, leading to an inefficient allocation of your monetary resources.

Most of us would be better off recognizing and addressing these mental accounting biases to potentially create a more balanced and aligned investment strategy that considers the broader financial landscape and long-term objectives.

Thinking Inside the Box

When making financial choices, we should consciously assess them based on their merits rather than which category the money comes from. This helps to avoid being swayed solely by the mental account the funds belong to. A continual focus on the right priorities is at the core of rational decision-making. It sounds easy, but the competing demands we face in life can sometimes take our attention away from what is truly important. A matrix below with examples illustrating what priorities are truly important or actionable can provide guidelines on what you should focus on.

Exhibit 1: Priority Matrix

Naturally, preventing mental accounting biases is a tough question with a lot of moving parts. But we should all be encouraged to talk it over with a financial advisor. If you don’t have one, this is a great reason to find one. You don’t have to deal with these tough questions alone. Make time for that important conversation with your financial advisor—the one where you tell them what goals really matter to you. It could change your life.