Mental Accounting – but for Investing

I’ve been on a bit of a ‘behaviourally informed investing’ kick lately, as with a forever looming recession, biased investing is likely to run rampant. That’s not to say investing in a market upturn is bias-free; it is most definitely not. It’s just that more damage tends to get done during a downturn. And not because it’s a downturn…

In the previous article I highlighted the 4 subcategories of biases I’m expecting to see most obviously, with people trying to ‘time’ their market exit, shift (some of) their assets to riskier asset classes and increasingly rely on others for guidance, also increasing their openness to getting scammed. But what if there was a way to avoid this? Or at least minimize some of this?

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I don’t think the average person will have the pleasure of sitting opposite a financial advisor: someone who will help you figure out how to manage your money. A large chunk of what financial advisors do is investing focused (assuming they’re working with relatively well off clients, who, paradoxically, may be the only people able to afford financial advisors to begin with). A financial advisors tends to operate in alignment with the financial hierarchy, to the extent that that makes sense for your lifestyle and your life goals. And then they try to hold you somewhat accountable, remind you of the longer-term plan and try to point out the risks involved with Bitcoin if you’re having a particularly bad month. Now you might be wondering where I’m going with this. But one of the easiest ways to seemingly minimize risk taking behaviours during a market downturn, is to approach investing from a mental accounting perspective; approach it like different pots of money. For those not in the know, mental accounting is a term proposed by Richard Thaler, who argues that most people when they receive their paycheck have a ‘distribution of resources’ already in their mind (the so-called mental accounts). Of a $2,000 paycheck people have an account for ‘rent’, ‘groceries’, ’car’, ‘fun’, ‘debt repayment’ etc. In their mind they allocate proportions of the paycheck to these goals; these mental accounts. The money is divvied up per purpose. And that money isn’t fungible (i.e. it does not move between accounts!).

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What would this look like for investing? Well if you’re proper wealthy and you’re investing according to different timelines and purposes, the divvying up almost takes care of itself: x% gets invested for retirement (to maintain the current lifestyle), another x% gets invested for retirement ‘fun’ (in addition to the current lifestyle), some more x% is for the kids and grandkids etc. etc. If you’ve got people who have a lot of experience with (self-directed) investing there might even be a small x% that’s just for messing about in the markets with themselves – keep a hand in – ‘play money’ if you will. As I mentioned, this is often how fund managers approach their clients to begin with. They know that their clients have different purposes for the same ‘blob’ of money and they act and invest accordingly. Because investing for these different pots would look different. The first pot ‘lifestyle maintenance’, depending on the time horizon of course, is most likely not going to be invested in very high risks stocks. It may be exclusively invested in ETFs. This investment ‘ mental account’ almost reads like an emergency fund. The ‘fun’ pot for retirement is of course a whole different story – it’s not ‘necessary’ money, but more of a ‘nice to have’, this might be invested much riskier, especially as this can be cashed out whenever meaning the client can wait out a market downturn with this money. When investing for future generations the timelines are much longer, meaning people tend to pivot to high growth investments. And then the ‘keeping a hand in’ account can truly be a hotchpotch of anything. Depending on the client’s wealth level this can range from crypto to individual stocks to buildings.

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Now people with a financial advisor clearly have it made, but in a market downturn, that’s not the demographic I am worried about. They’re not the ones most at risk due to their own biases, because, well, they’ve got someone refusing to let them jump of the ledge. But if you don’t have an advisor and you find yourself on the ledge of ‘biased decision-making’ and your fear and loss framed mind is making you keen to jump off that ledge, well, I’m afraid your action bias is only going to plummet you deeper into the void. So let’s apply mental accounting to our own investments, shall we? Especially in a downturn it’s important to know what the long-term goal is here. Is there a long-term goal, or is this all short-term speculation? Much as per the example of the advisor’s client before, is this ‘play money’ or is this ‘lifestyle maintenance money’? And if you’ve got multiple goals for your money, and given the amount of money invested having multiple goals makes sense, what are the different strategies at play here? Luckily, these days it’s very easy to split out your mental accounts into real accounts, even when it comes to investing. You can have different apps or wallets in the apps (or websites, brokers etc.) that you use to invest with – that’s become incredibly easy! Just make sure that you don’t conflate the two. If I may give you one piece of financial non-advice: don’t come up with your strategies for investing your different pots of money (e.g. home deposit, retirement, dabbling) during the recession itself – if you’ve already lost money. As per the previous article, that’s not the best mindset to start with…

Would you consider using mental accounting for your investment strategy?