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:
- 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?
- 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.
