The Pschology Of Investing: 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.

Example

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.

Causes

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.

Mitigation

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.