How To Make Successful Investments Using Behavioral Finance

How To Make Successful Investments Using Behavioral Finance
How To Make Successful Investments Using Behavioral Finance

4. Mental Accounting

If you divide your money into separate accounts for subjective criteria, you’re engaged in mental accounting. The criteria might include the source of the income, as well as the intended purpose. For instance, income from a second job might be set aside to save for a vacation.

Mental accounting is very common, but it’s also a highly illogical way of thinking.

Saving that ‘special’ money for a vacation mightn’t make a lot of sense if you’re heavily burdened with high-interest credit card debt. This line of thinking serves to decrease your net worth and make you less financially capable in the future.

It’d make more financial sense to use that extra money to pay off any expensive debts.

But people place different values on certain assets. Money saved for college might be deemed too important to be used for any other purpose.

Different Accounts

Consider the following scenario:

Suppose you’d determined that you were going to spend $30 for a shirt, and that was the amount you had budgeted. But when you got to the store, you realized that you had lost the money. Would you get another $30 and buy the shirt?

Now suppose you hadn’t lost the money, but you bought the shirt and ruined it the next day. Would you get another $30 and buy a new shirt?

Most people would most likely purchase another shirt in scenario number one, but probably not in the second case.

Yet, from a practical standpoint there’s no difference. In both instances, you’re out $30 and you still don’t have a shirt. This explains mental accounting.

Should The Source Matter?

Most people will treat money differently, depending on the source.

Money that’s “found” or extra, such as inheritances, tax returns, and bonuses tends to be treated differently than money that’s regularly expected. “Found” money is much more likely to be spent in a frivolous fashion and much less likely to be saved.

But money is money, so it shouldn’t matter how you acquired it. It should be treated the same, because it is the same.

How This Influences Investing

Many people have odd ways of dividing up their portfolios. They’ll have a separate portfolio of lower risk investments and another portfolio for those that are higher risk.

The rationale behind this is that the higher risk instruments won’t negatively impact the return of the other portfolio.

This can lead the investor to put too much money in higher risk investments.

How To Avoid This Dilemma

Remember that all money is the same. It doesn’t matter how you got it or how you intend to use it.

Limit the silly spending of extra money by realizing that this “found” money is the same as money that you earned.

Saving money in a cookie jar where it isn’t earning interest (a savings account isn’t a lot better) doesn’t make sense when you owe money on a high interest credit card debt.

“An expert is someone who has succeeded in making decisions and judgments simpler through knowing what to pay attention to and what to ignore.” — Edward de Bono

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