How Mental Accounting Could Be Hurting Your Portfolio
Investors sometimes make irrational investment decisions. This phenomenon is commonly referred to as behavioral finance. One reason behind this phenomenon is mental accounting. Mental accounting can cause us to make suboptimal investing decisions.
This article will explore mental accounting, show how it affects our portfolios, and provide strategies for overcoming it.
What is Mental Accounting?
Mental accounting refers to the tendency for individuals to divide their money into separate mental accounts. These accounts are labeled and treated differently based on criteria such as the funds’ purpose, source, or original amount.
Daniel Kahneman and Amos Tversky first coined the term mental accounting in 1991. Amir Barnea and Yuval Itzhak’s 2009 research paper indicates that the concept has far-reaching implications as to how investors behave.
Mental Accounting and Investing
Mental accounting can have both positive and negative implications for investing. On the positive side, it can help us create and achieve our investment goals. For instance, if we want to save for future education expenses, we can set aside funds in a separate account with a strict savings plan.
This way, we don’t accidentally spend the funds on other things, which many of us could do if we kept the funds in our primary account.
However, mental accounting can cause us to make irrational investment decisions. For instance, we might be less likely to sell shares in a winning stock if we paid a higher price for the shares. The erroneous thinking behind that mental accounting is that we will lose money if we sell the shares for less than what we paid for them.
Therefore, we hold on to the investment longer than we should. Consequently, the value of the investment might drop, and we end up facing substantial losses.
Mental accounting can also cause us to shun high-yielding stocks because they have a low sticker price. In this particular case, we might reason that the low price is an indication of an eventual performance decline.
This misconception is misplaced because, in some instances, a low stock price may indicate mispricing, creating an opportunity to get in at an attractive price point. Misplacing such opportunities may negatively impact our portfolio returns.
How to Overcome Mental Accounting
Overcoming mental accounting requires a fundamental shift in thinking. We should avoid thinking about our investment portfolio as segmented, isolated units with set criteria. Instead, we should concentrate on the entire portfolio and its goals. Here are some ways to overcome mental accounting:
1. Rebalancing: Regular portfolio rebalancing helps to keep the portfolio on track. It involves buying and selling shares to bring the asset allocation back to its original or target strategy.
2. Consider the Overall Portfolio: Investors should treat their portfolios as a single, cohesive unit. We should track their performance and goals, not separate parts, to determine if they are meeting their targets or not.
3. Adopt a Long-Term Strategy: Consider long-term investment horizon when setting goals and decision making. Create a strategic plan that outlines goals, investment strategy, and timelines. Stick to the plan when investment decisions are made.
The Bottom Line
Mental accounting can help us with short-term money management goals, but it can also lead to suboptimal investment decisions. It can cause us to make irrational investment decisions that could negatively impact our portfolio returns. Overcoming mental accounting requires a fundamental shift in thinking.
Investors need to treat their portfolios as a single, cohesive unit and always have a long-term investment horizon in mind. By doing this, investors can avoid the pitfalls of mental accounting and improve their portfolio performance significantly.
FAQs:
1. What is mental accounting?
Mental accounting refers to the practice of dividing money into separate mental accounts based on criteria such as purpose, source, or original amount.
2. What are the implications of mental accounting on investing?
Mental accounting can have both positive and negative implications for investing. While it can help us create and achieve our investment goals, it can also cause us to make irrational investment decisions that could negatively impact our portfolio returns.
3. How can investors overcome mental accounting?
To overcome mental accounting, investors should treat their portfolios as a single, cohesive unit, track their performance and goals, and always have a long-term investment horizon in mind. Regular portfolio rebalancing can also help.
How Mental Accounting Could Be Hurting Your Portfolio
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