Human beings like to sort things – we like to create order, we like to know where things are. We have a built-in need to spot patterns, which is why we like to sort music into genres, pore over the season record of our favourite football team or, for those of us old enough, arrange our CDs and DVDs in alphabetical order.
Our tendency to see (and to look for) familiar patterns can be really helpful, but if you’ve been reading this series so far, you’ll probably have spotted a pattern here too. If so, it won’t surprise you to hear that this quirk of the mind can be seriously unhelpful when you’re investing.
When it comes to our money, many of the instincts we’ve relied on since the dawn of mankind suddenly turn into loose cannons. These are our ‘behavioural biases’, the assumptions that lead us with ill-deserved confidence into poor financial decisions. This week, we’re looking at mental accounting.
What is it?
Mental accounting is another manifestation of our willingness to sort things into ‘jars’ or ‘buckets’ (or whatever metaphorical container you prefer). At some point we all separate our money into different ‘accounts’ in our mind’s eye, based on where the money came from and what it’s for. The birthday money you got will have to go towards the gas bill. The €500 in the credit union account you never touch is there for the group holiday you’re planning next year.
It can also affect how diligently we treat different repositories of money – for example, if you assume inherited money must be more responsibly managed than money you’ve won in a raffle. If you’ve ever treated one euro differently from another when you’re assessing its worth, you’re engaging in mental accounting.
When is it helpful?
In his early paper, Mental Accounting Matters Daniel Thaler, credited with having coined the term, describes how people use mental accounting “to keep trace of where their money is going, and to keep spending under control.” For example, say you set aside €250 per month for a fun family outing. This doesn’t oblige you to spend the money as planned or to stick to your budget. But by effectively assigning this function to that money, you’re better positioned to enjoy your leisure time, without overdoing it.
In reality the money isn’t moving anywhere, nor is it worth any more or less. It’s no different to the other money that you’re nonetheless treating differently. What mental accounting does is build a kind of augmented reality framework that helps us to get around our finances from day to day.
When is it harmful?
The problem is that while mental accounting can foster good saving and spending habits, it plays against you if you let it undermine your rational approach to investing. Imagine you’re emotionally attached to a stock you inherited from a beloved aunt. She had shares in that company since the day they became available and she always loved whatever it is that they make. You may be unwilling to unload it, even if reason dictates that you should.
Understandable? Of course! A sound investment decision? No, not a bit of it – you’ve just mentally accounted your aunt’s bequest into a place that detracts from, rather than contributes to, your best financial interests.
Even with the coolest head and the coldest heart, we’re all swayed by our emotions and by associations that get in the way of objective rationale. That’s why it’s a good idea to have a professional financial planner in your corner when you’re deciding where your money should go. Their job is to bring that all-important objectivity – to put your money into jars, buckets, bonds or equities based only on the returns you’re likely to get.
Keep bias at bay
It’s surprising how hard it can be to simply let things be. Knowing why we react in the ways we do is the first step to avoiding the counterintuitive actions that can damage what we set out to achieve with our investments.
You can download Making Better Decisions: Know Your Behavioural Biases in full today.
Co-Founder & Director
Metis Ireland Financial Planning Ltd t/a Metis Ireland is regulated by the Central Bank of Ireland.
All content provided in these blog posts is intended for information purposes only and should not be interpreted as financial advice. You should always engage the services of a fully qualified financial adviser before entering any financial contract. Metis Ireland Financial Planning Ltd t/a Metis Ireland will not be held responsible for any actions taken as a result of reading these blog posts.