Saturday, 29 September 2018

Psychology and Investing: Mental Accounting and Framing Effect

Most of us separate our money into buckets - this money is for the kids' college education, this money is for our retirement, this money is for the house.   Heaven forbid that we spend the house money on a vacation.

Investors derive some benefits from this behaviour.

  • Earmarking money for retirement may prevent us from spending it frivolously.

Mental accounting becomes a problem, though, when we categorize our funds without looking at the big picture.

  • While we might diligently place any extra money left over from our regular income into savings, we often view tax refunds as "found money" to be spent more frivolously.  
  • Since tax refunds are in fact our earned income, they should not be considered this way.
  • For gamblers, this effect can be referred to as "house money."

We are much more likely to take risks with house money than with our own.

  • There is a perception that the money isn't really ours and wasn't earned, so it is okay to take more risks with it.  
  • This is risk we would be unlikely to take if we would spent time working for that money ourselves.

In investing, just remember that money is money, no matter whether the funds in a brokerage account are derived from hard-earned savings, an inheritance or realized capital gains.

Framing Effect

This is one other form of mental accounting.

The framing effect addresses how a reference point, oftentimes a meaningless benchmark, can affect decision.

Overcoming Mental Accounting.

The best way to avoid the negative aspects of mental accounting is to concentrate on the total return of your investments.

Take care not to think of your "budget buckets" so discretely that you fail to see how some seemingly small decisions can make a big impact.

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