Is Mental Accounting Bias Impacting Your Investment Returns?

mental accounting bias

What is Mental Accounting Bias and is it affecting the way you make investment decisions?  Consider the following as an example.  A hypothetical investor Joe has 3 separate Investment accounts:

  • A deferred compensation plan to which he contributes
  • An IRA that his employer contributes to
  • A brokerage account he inherited

Joe thinks about these investments in separate buckets.  Joe has three portfolios, each with a separate goal:

  • The deferred compensation plan is for Joe’s retirement and has a 100% allocation to a Stable Value Fund with a 1.9% expected return generated by short term (0-3year) fixed income investments
  • The IRA is for a new convertible when Joe retires and, maybe a down payment on a beachfront condo if the investment really takes off. The IRA funds are invested in a high risk Emerging Market Equity Fund
  • The brokerage account will be used to fund living expenses and pay for his daughter’s college. Joe is focused on living off the income generated by the principal.  The brokerage account is split between a High Yield (junk) Bond Fund and individual dividend paying stocks

An analysis of Joe’s investment allocation highlights that he may have a Mental Accounting Bias.  Mental Accounting Bias results when investors treat separate buckets of money differently, based on the source of the funds or the goal assigned to the bucket. Let’s examine each of Joe’s accounts:

 

Account Source of Funds Goal Treatment of Funds
Deferred Compensation Joe’s Earnings Retirement Low Risk – Protect Contributions
IRA – Employer Sponsored Employer Car/Condo High Risk – Roll the Dice
Brokerage Account Inheritance Current Expenses Focus on Current Income – Not Total Return

 

Joe takes a cautious approach with his deferred compensation investments because all of the contributions were made by deferring employment earnings from his hard work.  He doesn’t want to risk this money because it’s for his retirement.  Joe treats his IRA account entirely different.  These funds were contributed by his employer so Joe doesn’t consider it in the same way he considers his deferred compensation plan contributions.  It’s found money and he’s willing to gamble with it.  Joe’s brokerage account is also invested differently.  He wants to generate current income with these investments and doesn’t want to dip into the principal.

There are some potential problems with the way Joe has invested his money that may result in sub-optimal portfolio performance:

  1. Joe is treating $1 of money is his deferred compensation plan different than $1 of money in his IRA plan
  2. Joe isn’t considering the way his investments are correlated because he views them as separate portfolios
  3. Next, Joe has focused on generating current income in his brokerage account and is ignoring total return
  4. Finally, Joe’s overall asset allocation results from the way his investments are allocated in the three separate accounts.

Is there a better way for Joe to manage his investments?  We think so.  Mental Accounting Bias can cloud your vision and obscure the big picture.  Consider the following:

  • First, Joe should consider all three of his investment accounts as one investment portfolio.
  • Joe should decide on an asset allocation to help him reach his goals. This allocation should be made considering risk & return, as well as any liquidity constraints (among other constraints) that Joe may have, such as paying for his daughter’s college tuition.
  • After Joe decides what his asset allocation should be, he can choose which investment accounts are best to hold specific investments.

By determining an asset allocation first Joe will neutralize his Mental Accounting Bias.  He’s no longer separating his investments into separate buckets to reach separate goals.  He now has one portfolio that has been constructed in a risk adjusted framework.  Joe’s new portfolio should improve his chances at reaching all of his goals.

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