Mental pitfall to avoid: mental accounting

February 23rd, 2010

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Following feedback from our readers, we learnt that many are interested in learning more about the mental pitfalls that afflict every human being. To be a good investor, one has to overcome or at least be aware of his/her vulnerability to mental pitfalls in order to make rational investment decisions. If you can do that, it will, by definition, make you a contrarian investor.

Today, we will look into mental accounting. In mental accounting, individuals tend to divide up their current and future assets into separate accounts and then assign different subjective values to these accounts.

Let’s look at the following scenarios:

  1. You divide your total wealth into two accounts: Retirement Account and Speculation Account. The former is meant to be ‘safe’ place to store your wealth for future retirement while the latter is for you to gamble in the financial markets. Say, you gamble $10,000 and lost the entire lot. Which outcome will make you feel better: (1) you lost $10,000 on the Retirement Account or (2) you lost $10,000 in the Speculation Account?
  2. Say you invest in stock A and B. The price of stock A decreased by 10% whereas the price of stock B increased by 10%. Let’s say you have to raise cash in a hurry. Everything else being equal, which stock will you liquidate in order to raise cash?

In the first scenario, chances are, a person using mental accounting will feel more pain in outcome (1). In the second scenario, one is more likely to sell the winning stock. But if one looks at them rationally, there’s no different between either outcomes in both of the scenarios.

The root characteristic of mental accounting is that it violates the principle that money is fungible. Recall that in Properties of good money, we wrote that

Any commodity that functions as money ought to be fungible. That is, you can trade or substitute it for equal amounts of like commodity.

To put it simply, a dollar is a dollar, no matter where it pick it up from. A dollar you deposit in the bank is not exactly the same physical dollar when you withdraw it three days later. But for all intention and purposes, both of them can be substituted for each other.

Diamonds, on the other hand are not fungible. Each is unique from the other and hence, cannot be substituted for another. Your pet dog is not fungible too. If it died over the weekend, you cannot simply pick a similar one from the pet shop and substitute it for your dead pet.

In the same way, a dollar in the Retirement Account is fungible from a dollar in the Speculative Account. But the fact that one is more likely to feel more pain from a loss in the Retirement Account then an identical loss in the Speculative Account shows that both dollars are no longer fungible in one’s minds.

Arguably, mental accounting helps make Kevin Rudd’s free $900 stimulus cheques more effective (in ‘stimulating’ the economy) then it would have been. Tax-payers who received $900 tend to put the that in the “Free Lunch” mental account. Money in the “Free Lunch” account is more likely to get splurged on consumer items that make one feel good. What if the government made that $900 be automatically credited into tax-payers’ debt account (e.g. mortgage debt, credit card debt)? In that case, most will be reluctant to spend $900. In both cases, the government spends $900 and each tax-payer’s network increased by $900. But the latter will result in most people choosing to close up their wallets. The rational choice in the former case would be to repay debts.

In another real-life example, one of our Chinese friends made an investment in physical gold and managed fund in 2007. As we all know, both the Chinese stock market and gold fell in the second half of 2008. By early 2009, he had made some paper profits in gold while the managed fund was still in the red. Due to some personal circumstances, he had to raise funds. So, he sold his gold for a tiny profit. Today, gold is at a much higher price than when he sold it and his managed funds is still in the red. The reason why he sold his gold was not because he believed that managed funds had a better prospect. Instead, he the reason was because he did not want to realise the losses in his managed fund.

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  • Pete

    Interesting article CIJ.

    This reminds me of a discussion I had with a friend about selling shares at a loss. The friend preferred to just wait it out and hope the shares would bring in a profit, even going so far as to buy more shares to bring down the average cost.

    I pointed out to him that to break even, his shares needed to go up by X% (let's say 20%). Rather than just 'hope' that the shares would recover, why not sell the shares and change to another company that is more promising?

    I said that things he should consider are:
    – why is it that the share fell in price?
    – is the share likely, in the current or perceived future economic conditions, to grow significantly?
    – are there other shares that you think have more growth potential? (assuming similar associated risk)

    It touched on topics that CIJ has previously written articles about, such as getting too attached to a particular company, or thinking that a share price will rise simply because you want it to.

    Fortunately for myself, I learned very quickly that selling at a loss is okay. In fact, pre-GFC I made some very good calls by selling shares at a minimal loss, to find out that company went bankrupt or fell significantly afterwards (I am partly praising myself and at the same time showing that I made losses).

    Although, this attitude has also brought me to sell winning shares too early (worst so far: buy 19c, sell 47c… went on to $1.80!).

    Somehow I think I went way off the point of this article, sorry.

    Remember, above is financial advice for Warren Buffet only.

  • @Pete

    Strong aversion against realising losses is one of the most common reasons why aspiring traders turn into long-term investor overnight.

  • Anon

    “This reminds me of a discussion I had with a friend about selling shares at a loss. The friend preferred to just wait it out and hope the shares would bring in a profit, even going so far as to buy more shares to bring down the average cost.”

    lol Pete, I've done this so many times even though I know it wont work. Its like self punishment over and over 😛
    Now i'm usually like, lets double it…next day…you idiot just get out :P. I use the fact that i'm doubling down as an exit signal now lol (unless i'm pyramiding upwards)
    If you buy extreme weakness blind freddy can pick profitable stocks ! Its so simple but most people freeze at the time its the easiest.

    “Although, this attitude has also brought me to sell winning shares too early (worst so far: buy 19c, sell 47c… went on to $1.80!).”

    I think thats the right attitude. I'm holding too long and selling abit late. Better to not overstay the party and be there for the hangover !

    Also I think a big thing i've learnt is flexibility of thought. You tend to be wrong alot, so you cant fall in love with certain ideas.
    Trusting your gut and intuition is a biggie aswell.

    Remember above not advice, just discussion — seek financial advice from a financial adviser.

  • Anon

    Another pitfull is opening your mind to ideas.
    When people get burnt doing something they are reluctant to try again and extrapolate that it never works and the whole idea/process/person is flawed.
    I did this with Marc Faber recently. I thought because he made a few bad calls he was always going to do this lol. Then he was the only one to get the latest correction right rofl.
    So I think a better way is to listen to everyone, assume everyone has something to offer, but then be selective and cautious as to what you listen to and what you dont.

    Remember not advice just discussion — seek financial advice/info/decisions from a financial advisor.

  • pb

    thanks for the article cij,

    in that scenario, i too would have wanted to avoid realising a loss on the managed fund. now i know better. it appears that the logical decision is harder to take sometimes, definitely a mental pitfall.

  • dsylexic

    well, financial advisors are subject to the same biases.in fact those seeking financial advisers are playing into the self attribution bias trap. if you do well,you can praise yourself -if your shares tank,blame the advisor