A bit more of mental accounting

Recently there has been a lively discussion among the Singapore Financial Blogger Scene about ‘Net Worth’ and how it should/could/may be computed (here, here, and here).

This showed me how imperfect and susceptible to bias we all are.  We are all in this together facing our cognitive illusions.

Let’s check out one common bias known as the Mental Accounting Bias, which is the tendency to value some money less than others.

Mental Accounting BiasOne example of this is the “House Money” effect:

In the event that you are gambling at a casino (a highly hypothetical scenario, because readers of financial blogs do know that the casino always wins—having the odds vastly skewed in their favour—and that casino gambling represents negative-sum gaming in its purest form, and thus put their money to work in areas with better risk/reward ratios, and only view casino gambling as an entertainment outlet, to watch desperate people in action).

Anyway, to return, after that monster of a sentence, to the subject of mental accounting: In the event that you are gambling at a a casino and have been fortunate enough to win, you might tend to be more risk-seeking with your earnings (“House Money”) than you would be with your principal (“Your Money”).

One area of this mental flaw that is especially dangerous to your investment portfolio is Financial Fees.

Fees on items like mutual funds and financial advisors are typically charged as a percentage of assets and not as absolute values.  Perhaps you pay 1.5% for your unit trust, or 1% a year to your financial advisor.

Those numbers may sound very small; one and a half percent, one percent.  And because they’re so minuscule—and only a small percentage of one’s assets—people tend to dismiss them as irrelevant.

But their impact can be huge, because one percent of a million-dollar portfolio is $10,000 per year, every year, for as long as you’re invested.  One percent may sound like nothing, but $10,000 likely does.  And it could easily be one of your biggest single annual expenses.

That’s the problem when we think about money in percentage terms, because when we contextualize spending against big-ticket items—a car, or an investment portfolio—we tend to make decisions that seem right for that purchase but would, nonetheless, seem wasteful and extravagant in any other area of our life.

That’s the reason why I paid excessively for my car and car radio (Relative-Dollar-Bias), and also why most of us pay excessively for management fees for unit trusts (Mutual Funds vs ETFs)1).  When it comes to investing, it’s really important to treat all money as one account; hence,

Mental Accounting BiasDon’t mix and match your “mental accounts” even if you have physically separated  the investment accounts for valid reasons—investment horizons would be one, taxation, another.

Don’t keep “safe” and “risky” investments in different accounts.

Don’t deceive yourself that some money is more important than others: it’s not.

And do ensure that when you track your investments, you do it all in one place.

Because a bit of conscious thought does go a long way towards correcting any snap bias.

Finally, having a definite purpose for accumulating a large nest full of eggs does no harm.

 

 

1) Expense ratios—the cost of fund ownership expressed as a percentage—continue to drop like a stone.  Some cheap index funds now cost less than $10 a year in fees on every $10,000 invested!  Vanguard seems to set the benchmark with as low as $3.  Now compare that to many mutual funds that can cost $100, even $200 every year in expenses.

A difference of $100 might sound minuscule, but consider this: a 1-percentage-point difference (in expenses on a $10,000 investment making 6% a year) will result in a nearly $14,000 difference in returns over the course of 30 years.

 

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