Why Investors Do What They Do: Mental Accounting

Many of us can rattle off the balance in our set-aside accounts, the small stashes of money we allot for some special purpose. These accounts, whether they be for a down payment on a house or a vacation have been designated for something and when you mentally account for this money, you put a barrier around your access to it.

These are essentially illiquid accounts - at least in your mind. This type of thinking and the ability to strictly categorize is a special talent that many of us have and some of us need to work on. If you are able to keep even so much as a general budget of your household, you are probably using this kind of separation technique to make sure ends meet and the other accounts you have set-aside do not become victims of a small loan.

Retirement accounts, even those with restrictions on how you may access the principal amount you have contributed (penalties for early withdrawal, tax consequences) are good examples of this kind of behavior. Setting aside money to grow and adding to it on a regular basis is mental accounting. These kinds of accounts are often of the traditional 401(k) and IRA variety. It should be noted that one of the major selling points of the Roth IRA and Roth 401(k) is the access you have to your principal.

Mental accounting really becomes a problem, almost without noticing it has, is when you separate different elements of an investment. Some are willing to pay higher fund expenses in return for a riskier fund that has done well in the past. This is a cost trade-off that you make using this type of accounting error. Another example might be a bond fund that entices investors with a high yield but the underlying investment is losing capital.

(This last example is why there may be a flaw in the thinking that we overload a portfolio with dividend paying investments at the end of our careers. Once we begin drawing down the underlying investments, the dividends will also fall and this will lead to a quicker drain on the account.)

Much of this has to do with our love affair with our investment picks. Only the most hardened among us can engage in the cold-calculations that stock pickers really employ. Listen for the insincerity when a talking head on television begins a conversation about an investment with "we really like this stock...". That is, until something changes.

Mental accountants ignore these warning calls and often miss selling winners when they are winners and even worse, selling losers when they are losers. This throws the whole diversification within a portfolio out of whack. While we are still working, it pays to focus how we bracket our investments. Keep in mind that studies have proven beyond a doubt, bets on long shots increase as the last race approaches.

If you find evidence that an investment has changed, and some suggest that loss aversion plays a role in this type of mental reasoning, you need to reposition your portfolio. This is not as hard as it seems nor does it require as much time as you might think.

It does however require you open your statements when they come each quarter or look at them online once a month. Set-up a Google alert for each underlying investment (a good retirement account should have no more than eight mutual funds and as little stock as possible) or build a sample portfolio at anyone of the sites that provide the free service. At the first hint of doubt, investigate and make a decision on what you should do with the whole of the portfolio as the benchmark, not the performance of the individual holding.

Next up: Diversification