Emancipate yourselves from mental slavery; none but ourselves can free our mindsBob Marley
Mental accounting involves treating one dollar different from another, depending on where it comes from, where it is kept, and how it is spent.
This can lead to being too quick to spend, too slow to save, and too conservative or aggressive with investing. For example, receiving a gift from a grandparent might seem more valuable than the same dollar amount earned from a job. So that gift might be invested more amount earned from a job. So that gift might be invested more conservatively than money earned because losing “grandma’s” money would be more traumatic than losing one’s own money. Mental accounting can also be affected by the amount of money involved. For example, most people would go to greater lengths to save $25 on a $100 purchase than they would to save $25 on a $1,000 purchase—the $25 seems to have more value with the $100 purchase.
Mental accounting can lead to being too quick to spend, too slow to save…
Mental accounting is the reason investors divide their assets into different
pockets, and therefore interferes with thinking of their overall portfolio.
To illustrate this concept, assume a person invests $1,000 in a speculative stock and in two months sells the investment for $4,000. With mental accounting, the investor will then be more conservative when reinvesting the $1,000 (since that was his “real” investment) and tend to take greater risks with the $3,000 profit. This is called the “house money effect,” because it is similar to a gambler thinking of the $3,000 as the “house’s money.” And if it is lost, well, it wasn’t really the gambler’s money to begin with. Of course, the $3,000 really is the investor’s (or gambler’s) money, but it is thought of differently. This compartmentalization not only distracts from considering the total
Mental accounting is the reason investors divide their assets into different pockets, and therefore interferes with them thinking of their overall portfolio.
For example, an advisor may put together a “total portfolio” for a client who has an individual account, a 401(k) plan, and two IRA accounts. The advisor would develop an asset allocation strategy spread across all the accounts, but would view all of the accounts as just one big account as far as asset allocation was concerned. A year later the client says to the advisor “I see that most of my accounts did well, but the one IRA accounts seems to have lagged behind. Why don’t we move out of the investments in that IRA and buy more of what we have in the other accounts?” This would be an example of mental accounting. Read about Money Behavioral Mistake #5. Anchoring.
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