Are you suffering from a bad case of mental accounting?
Thanks to The Canadian Money Reviewer for the opportunity to guest post. My handle is Free@45 and I mostly write about Educational Technology topics but have been firmly focused on finance, financial goals and wanted to share a few tidbits about what I have learned.
Is Mental Accounting Negatively Impacting the Growth of Your Investment Portfolio?
I have recently enjoyed the book “Why Smart People Make Big Money Mistakes and How to Correct Them: Lessons From The New Science Of Behavioral Economics” by Gary Belsky and Thomas Gilovich. One of the many interesting topics that were covered in the book was the idea of “mental accounting.” The concept outlined by Richard Thaler in 1980, attempts to describe the process whereby people code, categorize and evaluate economic outcomes. Mental accounting theorists argue that people group their assets into a number of non-fungible mental accounts.
Let me try to explain how I understand the concept and how this might be helpful or harmful to you:
So you receive a $5000 inheritance from your grandmother who grew up in the depression. You stick the inheritance in an account that is very low risk – say a GIC or High Interest Savings account because you feel that your grandmother wouldn’t have taken on higher risk with that money, so you shouldn’t either.
Another example is putting money inside an account that is mentally accounted for as a vacation fund. You put $300 there, month after month, over a year; all the while carrying a Credit Card loan of $2000 @ 18.5%. If you had not mentally accounted for this money as a vacation fund, you could pay off the credit debt and then start saving for the vacation.
Mentally accounting for money in the last two examples leads to both an ultra-conservative approach to investments and an inefficient debt repayment strategy. How might mental accounting help you?
Well, I am a recent convert in saving for bigger purchases, rather than using consumer debt to pay for them. Don’t buy it if you can’t afford to pay for it right away. We don’t carry any significant consumer debt, a couple hundred on a Capital One (Prime + 0.9) credit card. This was not always the case, but we have worked hard in order to make it the case. My family is in maternity leave mode, but before our second child was born, we calculated what type of money we would need for the extended maternity leave and were able to save it. So when my wife goes back to work we should not have any consumer debt that had helped pay for the maternity leave. It also means we will be able to shift back into investment mode when my wife starts working full-time again.
Having calculated our retirement numbers for age 45, 50, 55 it gives us a financial goal to aim for. It also helps us to determine what amount that we would need to invest in order to achieve these numbers. I don’t think we need to squirrel away every dollar into investments, if we are incurring significant consumer debt to do it. Also, we need to balance the needs of today against future needs.
Now, if I were take mental accounting at face value this last example could follow along the first two examples as a conservative use of money that could be better directed into a riskier investment with a better return, subtracted from the rate of interest from a line of credit. Still, I need to create a balance, and as long as our investments are on track, why not save for those big purchases? It might also help avoid over spending, which can easily occur when buying using credit. This might balance out any gains made from a riskier investment.
Maybe you have a different interpretation of mental accounting? Love to hear your opinion.
Reference: "Mental accounting - Wikipedia, the free encyclopedia." Main Page - Wikipedia, the free encyclopedia. 14 Feb. 2008
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