01-05-2011, 07:23 AM
A good article which summarizes the Behavioural Finance trait of "Mental Accounting". Enjoy!
Happy Labour Day!
May 1, 2011
small change
Don't go too far with mental accounting
To insist on compartmentalising your money into separate accounts could hurt you financially
By Gabriel Chen, Finance Correspondent
I handle the funds in my POSB savings account with prudence and care. I want them to grow over time so I will have enough for my retirement, mortgage and other serious financial purposes.
I use my OCBC Bank savings account to buy and sell shares, treating the monies there more speculatively.
At first glance, this has the makings of sensible decision-making. It seems reasonable to clearly delineate between my safety capital and the money I can afford to lose. Also, earmarking money for my retirement needs may prevent me from spending it frivolously.
But in reality, any dividing line between a safe and speculative portfolio is nothing more than a misleading mental illusion. Despite all the work and time that I spend to separate my portfolios, my net wealth will be no different than if I had held one larger portfolio.
Here, I fall prey to a psychological heuristic known as mental accounting. This is the tendency for people to separate their money into separate accounts based on a variety of subjective criteria like the source of the money and intent for each account.
Behavioural economics pioneer Richard Thaler, who first coined the phenomenon, cites mental accounting when describing why it is so hard to find a cab on a rainy evening.
Cab drivers tend to knock off for the day after they reach a certain level of income - in other words, when they hit their mental income targets for the day.
Business is brisker on rainy evenings, so they will hit their mark quickly and knock off early. This in turn explains why there are noticeably fewer cabs on the street, according to Dr Thaler.
Mental accounting has enormous consequences in everyday life. It affects how people spend money and how they save; it influences how people deal with losses and windfall gains; and it determines how people think about finance and make financial decisions.
The advantage of this approach is that it enables people to evaluate their decision in isolation from other transactions, which then makes their assessment easier.
But if we are not careful, compartmentalising income and spending into different mental buckets can put us in a financial fix.
For example, some people have a special fund set aside for important purposes, such as a new home or their children's university education, while still carrying substantial credit card debt.
The logical thing would be to use the funds or any other available monies to pay off their debt. But these people are reluctant to do so because of the personal value they place on particular assets.
In this case, the mortgage or education fund is too important to relinquish, so they end up clinging on to the fund at the expense of their hefty debt.
Mental accounting explains why many shoppers eagerly snap up deals on items they do not need.
Seasoned shoppers often develop 'intuitive' notions of what this or that item should cost, and they typically stack it up against their expectations and biases.
When an item is at a substantial discount to what they are used to seeing, they sometimes buy it for that reason alone, just to feel they have snagged a good deal.
Another aspect of mental accounting is that people have a tendency to value money differently depending on where it comes from.
People are more likely to be impulsive or reckless with 'found' money such as work bonuses and lottery winnings.
For example, people who win $500 in the lottery - considered found money - are more likely to spend those takings on 'junk' than if they had earned that $500 on the job.
Partly due to mental accounting, it is also not uncommon to find some investment banks sending out memos during bonus time, reminding employees that those bonuses may be lower in subsequent years depending on market conditions and other external factors.
They encourage employees not to view bonus levels as a guarantee of minimum payment in future years, and particularly not to spend in anticipation of similar future bonuses.
For me, I try to avoid the mental accounting bias by reminding myself that money is fungible in that a dollar is a dollar, no matter where it came from, where it is located, or what I plan on buying with it.
While embracing this mindset is often desirable, it is not easy in practice, according to Barclays Wealth's head of behavioural finance Greg Davies.
Dr Davies suggests that people always strive to look at the big picture. 'Start with a review of your total wealth to understand this picture,' he tells me.
Next, as an extension of money being fungible, identify where you have financial assets earning less in interest than you are paying on loans. 'Then use the assets to pay down the loans,' he says.
gabrielc@sph.com.sg
Happy Labour Day!
May 1, 2011
small change
Don't go too far with mental accounting
To insist on compartmentalising your money into separate accounts could hurt you financially
By Gabriel Chen, Finance Correspondent
I handle the funds in my POSB savings account with prudence and care. I want them to grow over time so I will have enough for my retirement, mortgage and other serious financial purposes.
I use my OCBC Bank savings account to buy and sell shares, treating the monies there more speculatively.
At first glance, this has the makings of sensible decision-making. It seems reasonable to clearly delineate between my safety capital and the money I can afford to lose. Also, earmarking money for my retirement needs may prevent me from spending it frivolously.
But in reality, any dividing line between a safe and speculative portfolio is nothing more than a misleading mental illusion. Despite all the work and time that I spend to separate my portfolios, my net wealth will be no different than if I had held one larger portfolio.
Here, I fall prey to a psychological heuristic known as mental accounting. This is the tendency for people to separate their money into separate accounts based on a variety of subjective criteria like the source of the money and intent for each account.
Behavioural economics pioneer Richard Thaler, who first coined the phenomenon, cites mental accounting when describing why it is so hard to find a cab on a rainy evening.
Cab drivers tend to knock off for the day after they reach a certain level of income - in other words, when they hit their mental income targets for the day.
Business is brisker on rainy evenings, so they will hit their mark quickly and knock off early. This in turn explains why there are noticeably fewer cabs on the street, according to Dr Thaler.
Mental accounting has enormous consequences in everyday life. It affects how people spend money and how they save; it influences how people deal with losses and windfall gains; and it determines how people think about finance and make financial decisions.
The advantage of this approach is that it enables people to evaluate their decision in isolation from other transactions, which then makes their assessment easier.
But if we are not careful, compartmentalising income and spending into different mental buckets can put us in a financial fix.
For example, some people have a special fund set aside for important purposes, such as a new home or their children's university education, while still carrying substantial credit card debt.
The logical thing would be to use the funds or any other available monies to pay off their debt. But these people are reluctant to do so because of the personal value they place on particular assets.
In this case, the mortgage or education fund is too important to relinquish, so they end up clinging on to the fund at the expense of their hefty debt.
Mental accounting explains why many shoppers eagerly snap up deals on items they do not need.
Seasoned shoppers often develop 'intuitive' notions of what this or that item should cost, and they typically stack it up against their expectations and biases.
When an item is at a substantial discount to what they are used to seeing, they sometimes buy it for that reason alone, just to feel they have snagged a good deal.
Another aspect of mental accounting is that people have a tendency to value money differently depending on where it comes from.
People are more likely to be impulsive or reckless with 'found' money such as work bonuses and lottery winnings.
For example, people who win $500 in the lottery - considered found money - are more likely to spend those takings on 'junk' than if they had earned that $500 on the job.
Partly due to mental accounting, it is also not uncommon to find some investment banks sending out memos during bonus time, reminding employees that those bonuses may be lower in subsequent years depending on market conditions and other external factors.
They encourage employees not to view bonus levels as a guarantee of minimum payment in future years, and particularly not to spend in anticipation of similar future bonuses.
For me, I try to avoid the mental accounting bias by reminding myself that money is fungible in that a dollar is a dollar, no matter where it came from, where it is located, or what I plan on buying with it.
While embracing this mindset is often desirable, it is not easy in practice, according to Barclays Wealth's head of behavioural finance Greg Davies.
Dr Davies suggests that people always strive to look at the big picture. 'Start with a review of your total wealth to understand this picture,' he tells me.
Next, as an extension of money being fungible, identify where you have financial assets earning less in interest than you are paying on loans. 'Then use the assets to pay down the loans,' he says.
gabrielc@sph.com.sg