Behavioural Finance: Mental Accounting

Another great question from a reader: 

"Can I have 2 separate accounts, one for investing in your portfolio models and one for my house money?".

We can make the assumption that at some (at the moment unidentified) point of time in the future, there is the desire to purchase a house. I won't get into the debate about whether a house purchase makes sense or not because that becomes the realm of a wealth forecast and is a highly personal (and perhaps emotional) decision. There are plenty of risks involved in home ownership and our job is to identify them and quantify them in the context of a family's goals and needs (which allows them to make an informed decision). It is however, their decision.

Back to the answer to the original question:

Of course you can, but why would you?

It is natural human behaviour to want to categorize different classes of the same basic asset: money.

It however, doesn't really matter:

If you have a $500,000 "investment account" that earns an annual total return of 5.5% (before fees and taxes)  and a $250,000 "house account" that earns 1% annually, then you actually have $750,000 that earns 3.9%.

But people like to separate "risk" money from "safe" money, because the pain of loss is greater than the pleasure of gain. It is, according to Richard H. Thaler (one of the foremost experts on Behavioural Finance), part of "the set of  cognitive operations used by individuals and households to organize, evaluate and keep track of financial activities."

http://www.anderson.ucla.edu/faculty/keith.chen/negot.%20papers/Thaler_MentalAccounting99.pdf

The theory behind "Mental Accounting" can often lead to decisions which may have irrational and detrimental impact on their consumption decisions and behaviour.

If you have a $500,000 investment portfolio earning 5.5% (or more) annually, why would you rush to use that money to pay down a line of credit or mortgage that has a cost of 2.5-3% just because you don't like debt?

And vice-versa: if you have a mortgage or line of credit at 2.5-3%, why would you put money in a (safe) savings account earning less than 1%. Especially if it is the held at the same institution because they are thrilled that you are paying them 2.5-3%  (to borrow from them) on one account and they are borrowing from you at 1% on the other.

Basically, all money is "fungible": whether you "worked" for it or "found" it (unexpected windfall), it is the same and its use all has risk associated with it.

If you spend it, you don't save it.

If you want it to grow, then you have to ensure that its growth is at a rate above the growth in the cost of the things that you will need to eventually purchase with that money (inflation). You also need to ensure that the risks of getting that growth are suitable.

Need help with that concept? (or other feedback)

scott@highrockcapital.ca

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