Mental accounting bias. In asset allocation, all baskets of eggs are equal.

Mental accounting bias is a cognitive pattern whereby individuals group their assets into several mental accounts and subjectively assign different values to each. Making several layers, one for each investment objective or risk appetite, within one portfolio ignores correlations between individual assets and results in sub-optimal portfolio returns. Discover whether you are prone to mental accounting bias and the extent to which it affects your investment decisions with  PRAAMS BehaviouRisk.

Behavioural economics. What is mental accounting bias?

This is a psychological pattern whereby an individual tends to group his assets into several mental accounts, and subjectively assigns different values to each. For example, a person can categorise his wealth by its source (e.g. salary, bonus, inheritance, insurance payment) or investment objectives (e.g. leisure, savings, basic needs). Another example is treating certain sums of money as ‘easy come’: found money, presents, lucky lottery or casino gains etc. Labelled as such, individuals are more inclined to spend them faster and with fewer worries and to bet with this money on a riskier trade idea more easily and regret less if the stake did not win. Easy come, easy go indeed! Another example of mental accounting is when an individual is less likely to buy something if forced to pay in cash rather than with a credit card. The mental category of ‘credit card money’ is viewed as future money, whereas ‘cash money’ is considered current money, usually perceived as more valuable. Money labelling makes no sense: $1 is $1 regardless of the artificial mental account into which it is deposited.

What are the consequences and investment risks? 

The first is creating layered portfolios, i.e. mentally dividing the portfolio into several layers, with each targeting a different strategy and risk appetite. For example, the first layer pursues wealth preservation, the second, aggressive capital appreciation, and the third, moderate capital appreciation and constant income flow. Strongly pronounced mental accounting sees an investor considering these layers unrelated, as each targets different financial goals. However, the layered approach ignores the crucial fact that the assets in these layers may correlate and thus offset each other on a combined or portfolio level. For example, the fall in the value of one layer may offset the gains of another layer, rendering the portfolio return suboptimal.

Another type of layering relates to the intended use of the funds from portfolio management. Many investors, for example, treat one layer of their portfolio as intended for pension, another for college debt payoff, and a third for current income.

The third type of layering treats returns from dividends or coupons and returns from capital appreciation differently. An investor with an investment objective of wealth preservation focuses on preserving the principal and tends to spend the dividends and coupons. Similarly, an investor focusing on a current income strategy tends to prefer instruments that pay high dividends or coupons and, as a result, forces himself into higher-risk investments where the principal is at greater risk.

The fourth type of layering is about treating initial investment and earned returns differently, as with the ‘easy come, easy go’ effect above. It is typical for such an investor to make higher-risk investments as returns accumulate and his total wealth grows. This investor feels he has been doing well and has earned enough to assume riskier bets.

Layering ignores the correlations between individual assets, worsening the total portfolio return. Behavioural science is correct in stating that layering has no rational grounds. Consequently, at PRAAMS, we conduct a risk analysis of individual assets and evaluate their correlations at the portfolio level, as both are critical.

What can I do to make my portfolio more efficient?

Dividing your wealth or investment portfolio into layers makes no sense and may even be harmful. It is wise to recognise this temptation in the early stages and come to terms with it. It is the total portfolio return that matters, nothing else. Diversification is one of the fundamental strategies required to achieve stable and predictable portfolio returns. Also, it is wise to remember that $1 is always $1 regardless of its source, intended use, or one’s level of wealth. A $100 lottery win is the same as your grandmother's $100 birthday gift cheque, and its value is the same whether you have a portfolio worth 10 thousand or 10 million.