Mental Accounting

Mental accounting is the term given by psychologists to our habit of shifting perspective based on our circumstances. If we find money that we had previously lost, the find is treated as a windfall and spent frivolously. It was always our money, it took the same length of time to afford to buy it, and yet lost and found never has that seriousness about it that it did when we first lost it.

Another mistake is to think of your investment "paper profits" as another kind of money. There is an old gambling parable told in Las Vegas about a man that starts with $5.00, gambles this up to $262 Million playing roulette, then loses the lot on his next bet. Later asked by his wife about his performance that night, he said, "not too bad, I lost $5.00". In gambling people refer to this as "house money", and is a commonly observed phenomenon where gamblers become especially reckless with their profits, throwing aside whatever rudimentary money management strategy they had previously held themselves to. Many traders are guilty of the same thing, thinking that once their profits reach a certain point they can afford to take higher risks with their money and buy a few speculative stocks or throw it into a few long-shot puts and calls.

Mental accounting is also responsible for people's tendency to save money in term deposits paying 4% while they have a mortgage to pay, presumably at that same interest rate. It is important to keep a source of liquid funds at hand in order to meet emergency spending requirements, but a term deposit is not a liquid investment, there is typically difficulty getting money out immediately. Don't draw a line between loan money and investment money, don't go thinking that you are making a profit out of a cash management account even if it pays 6% interest and your mortgage is only slightly higher, in fact even if the cash management account paid a return a couple of percent higher than the mortgage, you pay tax on investment earnings but can't deduct the interest for a (residential) mortgage. To think that there is some kind of difference between loan interest and investment earnings is a form of mental accounting. A dollar is a dollar.

Thaler had another interesting experiment to demonstrate this. He gave $30 in cash to people and gave them the opportunity to either pocket the money, or gamble on a coin flip for an extra $9, or lose $9. Most (70%) took the gamble, thinking that at the very least they would walk away with a free $21. A second group was initially presented with different options, they were asked to choose either a $39/$21 gamble on a coin flip, or $30 in the hand. More than half (57%) took the money and walked. The numbers were very different even though the gamble, the payoff and the risk were all the same. How the money was presented affected how cautious people were with the money.

A humorous tale is told of the friend of one of the researchers that worked on the psychology of money management. This friend of his had a way of reducing the anguish of his misfortunes. At the start of each year he would plan to donate a sum of money to a charity at the end of the year. Every time an unplanned expense occurred, such as a parking fine, an investment loss or an unexpected expense like a car repair he would subtract this money away from what he was going to pay the charity. In this way he never felt the pain of loss because his charity paid for his losses instead. The researcher nominated his friend to be perhaps the world's first Certified Mental Accountant (CMA).

How we invest is thus a function of how we regard the money, not an absolute decision based on a risk-return strategy. When people get an inheritance they may well invest in a few speculative stocks for a punt, when they have to save the money for years they will invest in something with very low volatility.

A whole investment industry and investment philosophy (portfolio theory) has sprung up around optimising portfolios for volatility, at the expense of return. Warren Buffett and people of that ilk are at a great advantage to other investors because Buffett has something entirely different in mind. He'd rather take a lumpy 15% than a smooth 12%.

Risk tolerance is a big issue with brokers and financial planners seeking to keep their clients, they need to try to find out exactly what sort of risk profile an investor has in order to design a portfolio to meet their needs. Financial planners try to assess people's risk tolerance with questionnaires and interviews, constructing a risk profile for each investor. But people's risk tolerance is linked to emotion, and that changes as circumstances change.

Why do people invest 200% in shares during a bull market using borrowed funds, and yet put whatever they have left after the crash into bonds? Because all those with an aggressive profile before the crash suddenly become very cautious, their greed is inspired by the illusion of easy money, and the reality of their failure drives them to the opposite extreme.

The ideal psychology of investment is great faith in your own research and calculations, yet a contempt for luck and those that seek to take returns by speculation. It takes the greatest of psychological efforts to be apart from the herd, but it is the only hope one can have for making serious money long term in the market. This does not mean throwing caution to the wind and trading intuitively based on immutable faith in your own genius throughout a bull market, but it does mean you need to step back and take the unpopular position. Even if you don't take large bearish positions in the middle of a bull market, it does mean reducing bullish exposure as the bulls are at their strongest, and "backing up the truck" when everyone thinks the world is going to end. Even if the world does end, there could be no better time to be fully invested...