Sunday, December 30, 2007

Behavioural Finance Part 1 - Mental Accounting

This may sound ambitious, but I am starting a new series on behavioural finance as I feel it is very relevant to value investing and investing in general. I will be updating my investing sins and research series at the same time, so readers, kindly be patient. Most people actually lose money in the markets through their own mental faults, rather than a result of not being able to analyze a company objectively. Humans are natually emotional creatures (we are not robots !) and we tend to over-emphasize the emotional aspects of money in an unconscious manner. When dealing with the stock market, this can be counter-productive and extremely disruptive to wealth building. Charlie Munger (Warren Buffett's partner in Berkshire Hathaway) understood the basics of behavioural finance long before the experts took it up as a serious topic. Now, there is a whole field of study relating to it and experts acknowledge that a lot of research needs to be be done in order to ascertain the effects of behavioural finance on investing. Examples of topics I will be covering under this category are over-confidence, over-reaction bias, loss aversion and mental accounting.

The topic I would like to touch on today is mental accounting. Mental accounting is the process by which we tends to mentally segregate our money into various "buckets" for spending and utilizing. This can create problems because after all, money is money right ? Why should we separate money into distinct categories ? This is due to the fact that human beings like to compartmentalize money, and we do it unconsciously in everyday life. For example, we tend to mentally set aside $100 for meals every month, $80 for transport and say $200 for entertainment and leisure activities. Thus, it will not pain me if I spend $150 on a good concert because I had already mentally accounted for it. Assuming I am effective at budgeting, this will not be a problem; problems arise only if the mental accounting map had set aside $1,000 instead of $200 !

The above was a simple example of mental accounting, but the more pervasive effects can be found in stock markets and casinos. To illustrate, imagine a person winning $1,000 in a casino on his first few rolls, due to sheer luck. This $1,000 is then perceived as "bonus" money which can be spent frivolously as the gambler will not be fazed if he lost all of it as he did not have this extra $1,000 to begin with. In the end, the house always wins in a casino and he may very well lose the $1,000 he initially made, and probably his pants too if he is not careful ! The point here is that the extra $1,000 is still money, though it came from a windfall; but our minds automatically segregate it as "additional" money which can spent freely and with abandon. The wise thing to do would be to stop playing and keep the extra $1,000. (Better still, invest in and get a 5-10% yield !).

I have seen mental accounting very often in stock market behaviour, and have been victim to it myself (though I recognize it better now and take steps to tell my brain NOT to mental account). I often hear from friends who have gains in the stock market that these gains can very well be left to evaporate as "they were gains in the first place". Put another way, my friends feel that it is OK to lose money in a lousy company as the losses were originally made up of profits in the first place. This example is akin to the casino example I gave above, in that we tend to feel that profits can be lost without a blink rather than our own initial capital. If we put it in a rational perspective, and using value investing principles, every single cent of gain should be preserved as capital preservation is a cornerstone of value investing. This means that all gains should be retained and compounded to produce even better returns, instead of using those gains to "gamble" just because we have mentally accounted for it.

To conclude, mental accounting is a very subtle and insidious way of losing money which many people do not realize. It is time to ask yourself if you are guilty of this aspect of behavioural finance, and whether you can actively choose to prevent it from occurring again. In this way, we can all be better investors !

2 comments:

Anonymous said...

hi

i wonder if this is relevant to the topic of receiving a bonus or picking up some coins or notes on the floor.

Perhaps, if this money comes easily , then the person is less iclined to keep it , save and invest. Rather, they will be more motivated to spend it (god's gift).

Cheers

musicwhiz said...

Hello Anonymous,

Yes, you are absolutely correct. This also applies to money you "found" which we humans tend to regard as a "bonus" and thus it feels easier to spend. Strange huh ? :)

Regards, Musicwhiz