A lot of economic and financial research deals with behavioral biases, those occasions where the mind plays tricks with us and leads even very intelligent people down the path of irrational and sub-optimal decisions. Other bloggers have pointed out some of these biases before, see Plan Invest Escape on cognitive biases. Also, Northern Expenditure wrote an interesting post on the temptation of instant gratification over saving for the future. Among all the different biases, Mental Accounting is not that well-known but it’s one of the most fascinating. Mental accounting, sometimes called Framing, shows up in human behavior in the following ways:
Intentionally or unintentionally creating different buckets of money and ignoring the fact that money is fungible; displaying different degrees of risk aversion and/or different propensities to consume out of different buckets.
Quite intriguingly, in personal finance the mental accounting bias is not only committed frequently, sometimes it’s even celebrated as a great innovation. It’s not a defect, it’s a feature! Some of the well-known financial gurus fall for this fallacy and are not even ashamed!
The stereotypical (and relatively benign) Mental Accounting example is this: if you find a $20 bill between the sofa cushions, would you blow this windfall money on something you wouldn’t have bought if the money had been in your checking account all along? If yes, you seem to have different propensities to consume out of different pots of money. But money is fungible. In deciding if and how to spend the $20, it should not matter where the money came from. We gathered some other examples of mental accounting from around the web of how human behavior might display Mental Accounting:
They are all quite interesting and entertaining to read but still leave the impression that this bias is relatively benign, more of a little quirk that causes irrational behavior concerning trivial amounts like the $10 movie ticket or $50 of money blown on a casino visit. Who cares?
We should care because if you look carefully, Mental Accounting is everywhere in the personal finance world. We committed it many times ourselves. But when applied to large portfolios, potentially in the multi-millions, the damage is no longer trivial. Here are some examples:
1: Emergency fund
We are no friends of emergency funds. For us, our entire investment portfolio is our emergency fund, as we described in an earlier post. Having an outsized emergency fund in a money market account could be a sign of Mental Accounting. The one way to rationalize the emergency fund held in cash would be the risk mitigation argument, though it’s not that convincing. Specifically, take an example of someone with $100,000 in financial assets, $80,000 in stocks and $20,000 in an emergency fund held in a money market account. I can fully understand that someone is uncomfortable with the roughly 15% annualized risk a 100% equity portfolio would bring. So, if someone wants 12% risk and not a single basis point more one could argue that 20% cash is one way of getting there. But it’s not a very efficient way because you could also get to that same expected risk level by mixing in other uncorrelated or even negatively correlated assets (such as longer duration bonds) that have higher expected returns. You will get a higher expected portfolio return at the same risk level.
Side note for the Finance wonks: if you pick any point along the efficient frontier past the tangency point you have to hold zero cash. Thus, risk reduction is never done by raising cash, but rather by keeping cash at 0% and changing the asset mix along the efficient frontier, see the efficient frontier plot below and our analysis here.
By artificially constraining your portfolio into one risky and one risk-less bucket for emergencies, you likely get lower returns than having optimized one large portfolio with the same overall average risk target. So all the financial gurus out there who preach that the emergency fund can’t be invested in anything risky are making this mistake, violating Finance 101. And everybody goes “ooh” and “aah” about how smart this advice is. It’s not a defect, it’s a feature! But it’s an irrational bias and reduces expected returns.
2: Risk management and portfolio optimization by bucket
The emergency fund fallacy is actually only one facet of a much wider-ranging fallacy; the asset allocation decision in separate buckets. That’s typically sub-optimal and there are many examples of it:
Example 1: Robo-advisers
Robo-advisers are celebrated as the new rocket scientists in Finance but the idea of coming up with one target portfolio for the taxable account and one for the tax-deferred account as is practiced by Wealthfront and Betterment is entirely preposterous. There is a short questionnaire beforehand to determine the likely risk-aversion level, but even for a given risk aversion level, you shouldn’t optimize the taxable and retirement accounts separately. Examples:
- For the least risk-averse, Wealthfront recommends a 16% share in REITs in your retirement account and 0% allocation to REITs in the taxable account. How can that be optimal if we don’t know what’s the share of your taxable vs. retirement account? If it’s optional for someone with a 50/50 allocation between taxable and tax-deferred account (thus 8% average allocation to REITs), how can it be optimal for someone with only a tax-deferred account (thus 16% REIT allocation), or someone with only taxable accounts (no REIT allocation at all)? It doesn’t make sense at all!
- Both Betterment and Wealthfront recommend Municipal Bonds (tax-free interest) in their taxable portfolio. Betterment recommends even taxable bond ETFs in the taxable portfolio. That may be OK if you have only a taxable account and require some bond allocation. But if you also have a retirement account you’ll likely be better off keeping taxable bonds there and only equities (with qualified dividends) in the taxable portfolio, see diagram below.
- We list several more examples detailing how an individual with both taxable and retirement accounts would experience a sub-optimal allocation using the Robo-advisers. See our blog post here.
Whether this is ineptitude or laziness on behalf of the Robo-advisers, these are all textbook cases of mental accounting and they all generate sub-optimal allocations. Your portfolio allocation should be done globally over your entire portfolio first. Then you decide where to hold what, e.g., bonds and REITs in tax-advantaged accounts, equities with the lowest dividend yield in the taxable account first, then filling up the remainder of the tax-advantaged accounts.
Example 2: real assets/inflation protection
If I had a dollar for every time I heard things like “you need 10% real assets in your portfolio” or “you need 10% REITs” in your 401(k)” I’d be a rich man. How much you need in inflation protection depends on many factors. Are you a homeowner or renter? Do you own rental property? Will you get a pension with Cost of Living Adjustments (COLA) or a nominal payment or none at all? If you are a public servant with a pension that has COLA (cost of living adjustment), you may not need much inflation protection at all. Your goal shouldn’t be to inflation-hedge you 401(k) account, but to inflation hedge your entire lifetime financial situation, including (but not limited to) your retirement cash flow.
Example 3: ignoring other issues and risk factors outside of the portfolio
Back to the Betterment/Wealthfront Muni bond allocation: The Muni bond allocation seems independent of the income level (even though there’s a question about the income in the initial interview). Individuals in a low tax bracket may be better off with taxable bonds that tend to have a higher yield. Munis are mostly interesting for folks in the 35% and 39.6% federal tax brackets. Again, maximizing the portfolio allocation within one bucket without regard for the overall financial situation is sub-optimal.
3: Taking budgets too seriously
Having a budget is important, some even find budgets sexy. But taking the budget too literally could set you up for overspending. For example, if by the end of the month we are under budget in one category, there could be a temptation to “blow” the money on this category (or another for that matter). But some categories should always be under budget to hopefully average out unexpected spending shocks. Prime example: owning a home and/or a car one should clearly budget for replacing, repairing and maintaining the major components. If you have a budget of, say, $30 a month for fixing a certain component, and it doesn’t break in any given month, that’s not free money. Save it for when something does break and the $30 budgeted for the repair that month will likely not suffice.
How to avoid mental accounting:
- Repeat after me “money is fungible”
- Sometimes, splitting a larger problem into several smaller problems is the smart way to go, but in personal finance, you don’t want to miss the forest for the trees. Risk management and portfolio allocation should be done holistically, rather than separately in each bucket. Since the bucketing is irrational and leads to sub-optimal results, our solution is to have one and only one bucket: our investment portfolio. Of course, it is invested in different assets, but we always look at the portfolio as one pot of money.
- Careful with budgets. Of course, budgets are important. But if towards the end of the month/quarter/year there’s money left in the budget, don’t succumb to the temptation of overspending the leftovers. Use that as an excuse to lower the budget for that category in the future or save the excess for the inevitable large expenditure on major repairs.