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Wednesday 2 July 2014

M is for Mental Accounting

Mental Accounting is the term given for our habit of mentally allocating money to various accounts and then acting as though they're in separate high security vaults, transferable only by using a elite team of undercover operatives armed with a teleporter and a genetically modified ape. From there it's a short step to using our mental accounts to engage in some perverse and financially draining behaviors.


There are lots of simple everyday life examples, things like putting money in a jar for holiday spending. More damagingly, if people invest in the stock of their employers they seem to allocate that stock to a different mental account so rather than diversifying equally across all their asset classes they significantly overweight their company's stock (and end up overweight in stocks). This, of course, is hugely risky, as Enron employees discovered when they lost their jobs, their salaries and most of their investment savings in one fell swoop.

People also seem to segregate between "safe" investments and "risky" investments and will behave much more riskily with the latter than the former. Other common behaviors include selling half an investment when it's doubled and then letting the remainder "run for free". This type of narrow mental accounting can also be used to justify loss aversion, by grouping poor investments with other better ones in order to avoid facing up to a bad decision.


Mental accounting is, at least partly, a framing issue. By creating various frames - e.g. saving money for a holiday - we create the illusion that money isn't transferable between accounts when it might be advantageous for us to do so - e.g. paying off a high interest loan earlier. In many situations this doesn't matter a great deal but if we start manipulating those frames in order to allow other biases to creep into our investing activities in can be a very expensive trait.


When it comes to investing it's really important to treat all of your funds as one account. Don't mix and match mental accounts even if you have various separate investment accounts for valid reasons - tax efficiency would be one, for instance. Don't keep "safe" and "risky" investments in different accounts. Don't pretend to yourself that some money is more important than others: it's not. And make sure that when you track your investments you do it all in one place.


  1. I actually disagree with this. I think it is useful to segregate accounts. I have an emergency savings account, a core assets account, and then accounts for risk assets. I do not see all of my savings as equal available to risk. The peace of mind that comes from knowing I have cash reserves set aside is worth the opportunity cost IMO. Some money is in fact more important than others in that should the market crater, that lower risk money will grow in importance. It's easier to set aside a specific amount of both emergency money and lower risk money and then focus on maximizing the return on the rest than trying to manage it all as one big mess.

  2. I'm talking about investments rather than cash. I'd always recommend having an emergency cash account, and we all need money to live on. However, investment accounts should be viewed as a single entity. Otherwise we can end up doing some very odd things - take a look at Behavioral Portfolios for instance.

  3. I still really disagree. I view it as a multi-level system. Cash and total return (largely fixed-income) are put in separate accounts (emergency savings and core assets) and everything else is put into the risk assets account. The amounts for cash and total return are set as a % of income essentially, and grow accordingly. I find that having those set aside allows me to think more clearly about how I invest my risk assets and leaves me less concerned about trying to estimate the risk of a large combined portfolio. I have different return targets for each pool of capital, and each serve a different purpose. I'm comfortable shooting for a higher compounding rate on everything outside of what I view as essential buffer assets (x months of expenses in cash and a larger amount in safer assets). I've actually done a much better job at investing the risk assets since moving to this strategy.

  4. Downside and upside, it's a behavioral portfolio. It has the advantages and disadvantages of that approach for the reasons explained in the original research. On the basis described it should work perfectly well, but people often start shifting assets between the accounts in order to mask their biases: the challenge is to maintain the approach when market conditions change.

  5. That's fair. I'd like to think my current setup will leave me less likely to make behavioral mistakes, as the safe asset side will hold up in most negative market environments and hopefully I can accept that risk assets are just that. I have a long horizon, and I'm comfortable with my methodology for allocating capital. I can see how allocating to 'risk capital' can lead people to invest poorly with an unconscious willingness to lose that money, but my track record with investment capital so far is one of value investing and low variance/relatively high sharpe with a systematic bent to investing. I do see how having things separate could lead one to overestimate risk tolerance and stretch though. Only time will tell, and its worth keeping the behavioral pitfalls in mind more frequently.