3 Ways to Ruin Your Investing Strategy

 

Annalyn Kurtz

 

Investors beware: Your mind is playing tricks on you.

 

When you receive a tax refund or a bonus, you're probably more likely to splurge on a vacation or treat, rather than sock it away in your rainy day fund or retirement account. Perhaps you think of this sudden windfall as fun money. After all, it feels very different from the hard-earned paycheck deposited in your checking account.

 

But, guess what? The reality is that tax refund and bonus – they came from your labor, too. And in the end, the source of the income should not matter anyway.

 

The impulse to categorize money based on its source or its purpose is an artificial trick played by the mind, and it violates a basic rule of economics. A dollar is a dollar, regardless of where it comes from.

 

“We like to think of ourselves as beings of reason and logic, but our decisions are driven largely by instinct. How we behave in the world of finance and investing is no exception,” says Jason Kirsch, the founder of Grow, a financial planning firm based inSanta Monica,California.

 

If you’re like most people, you probably have a habit of dividing money into buckets, if not in separate bank accounts, then at least mentally. Those buckets might include money for rent and everyday expenses like groceries and gasoline, as well as accounts earmarked for retirement, a future down payment on a house, college tuition for your children or a dream vacation.

 

Likewise, we also tend to categorize income based on its source. Whereas a steady paycheck is deemed as money to be responsibly spent on paying the bills, cash won in a lottery, found on the sidewalk or received as a gift is thought to be fun money to be blown on a shopping spree or another luxury.

 

This psychological phenomenon is known as “mental accounting”, a phrase popularized by Richard Thaler, a behavioral economist at the University of Chicago’s Booth School of Business, and it’s important to understand how it can adversely affect your personal finances.

 

Here are three common ways mental accounting can lead to bad money habits.

 

Refusing to shift funds across accounts

 

One of the most classic scenarios of harmful mental accounting occurs when people compartmentalize their finances and view some of those compartments as untouchable.

 

Think, for example, of a family that sets funds aside in a low-interest savings account for a rainy day, but continues to hold credit card debt that is accruing substantially higher interest fees. These days, the average money market savings account earns just 0.12 percent interest annually, but the typical variable credit card comes along with a 16.7 percent APR, according to Bankrate.com.

 

Simply by using funds from the savings account to pay off the credit card debt automatically nets significant savings in interest charges, but many people don’t see it this way. They view the cash in the savings account as untouchable and distinct from the money they owe on the credit card.

 

“This is a good example where mental accounting can get in the way of good decisions,” says Meir Statman, a finance professor atSanta ClaraUniversityand author of “Finance for Normal People”.

 

Not adhering to a consistent investment strategy

 

Mental accounting can also counteract a well-planned financial strategy when investors set an asset allocation for one account, without considering the asset allocations of their other accounts.

 

“I see it a lot – people tend to think in buckets. They’ll have an account that’s the vacation account, kids’ education account, retirement account – it goes on and on,” says Dave Yeske, a certified financial planner and managing director of Yeske Buie.

 

“The other thing that people do is they get talked into making investments across many different firms,” he adds. “Pretty soon, you’ve got five or six of them, and it makes it very hard to think comprehensively.”

 

Investors should consider the ideal asset allocation across their entire portfolio first, rather than view each account in isolation, but this is more difficult than it sounds.

 

Take, for example, an investor who is saving for retirement and has determined that the optimal asset allocation for her portfolio is 75 percent stocks, 25 percent bonds. She may have many different accounts, including a taxable brokerage account and tax-deferred accounts like a 401(k) or individual retirement account, and it may make sense for some of these accounts to be invested more heavily in stocks versus bonds, depending on the tax implications.

 

But in aggregate, the accounts should still abide by the 75-25 allocation.

 

Failing to aggregate small, routine expenses

 

In mental accounting, large expenses tend to be tallied up appropriately, whereas routine everyday expenses are usually ignored.

 

A daily cup of coffee may cost only $3 and not seem like a splurge, but a 2013 survey by Accounting Principals showed the average working American spent $21.32 on coffee each week. This adds up to $1,100 ayear.

 

Maybe the happiness from that daily cup of Joe is indeed worth $1,100 ayear to the coffee drinker, or maybe it’s not. Either way, it’s important to be aware about the expense and how it fits into your overall financial goals.

 

How to use mental accounting to your advantage

 

“Despite these pitfalls, mental accounting is typically more useful than it is harmful,” says Statman, who cites it as an effective self-control mechanism.

 

“Having clear buckets that reflect an investor’s goals and values can help them stay on track,” he says.

 

As for sudden windfalls, Yeske recommends his clients set clear rules, coinciding with their overall goals and still allowing for some fun. That way, they won’t make rash decisions under a state of arousal. A simple set of windfall rules may look something like this: 70 percent to a supplemental retirement fund, 20 percent to a child’s 529 savings plan, and 10 percent to a “fun” fund for vacations or splurges.

 

Similar to a “fun fund”, Kirsch recommends the “sandbox and lockbox” approach to some clients – particularly those who may be prone to making sudden, risky decisions or investing in the latest trend. The client may set aside 5 percent of his portfolio as a “sandbox” to play with, but commits to keeping the other 95 percent in the “lockbox” for more traditional investments like index funds.

 

“The key,” says Hui-chin Chen, a financial planner for Pavlov Financial Planning inArlington,Virginia, “is understanding yourself and using your tendencies to your favor.”

 

“The phenomenon of mental accounting exists, but it’s not necessarily a bad thing,” she says. “In fact, by being aware of how we put things in different buckets, we can lead ourselves to better outcomes.”