Behavioral Bias: Avoiding Mental Accounting

People work hard for their money, spending decades saving for the future and building long-term investment portfolios that might someday sustain a lifestyle well beyond retirement. Without income, retirees often begin to tap into those investment assets to pay the bills. And when faced with the need to depart with those hard-earned dollars, protective instincts take hold, resulting in seemingly logical investment behaviors that actually cause the most damage to long-term financial security.

It’s a common refrain built on flawed logic: I should reconfigure my portfolio to generate income in order to cover my expenses. That way, I never touch the assets I spent my lifetime building. The premise of this thinking highlights one of the most common misconceptions about investment strategies for long-term capital needs. This psychological preference to spend only income stems from a behavioral finance flaw referred to as mental accounting, whereby we prefer to protect the original asset by only using new money gained. (For related reading, see: America's Epidemic of Financial Avoidance.)

Risks of Compartmentalizing Funds

Think of a gambler that wins in a casino. The gambler, like the investor earning income, did not have that money before, so he’s more inclined to play with his “house money” and not with the money he originally brought to the casino. It’s the same reason we’re more likely to use our tax refund rather than our savings to go on vacation. But in reality, money is fungible, meaning its inherent value doesn’t reflect how or where the value originated. Therefore, we shouldn’t compartmentalize the way in which we spend assets. Whether we spend our tax refund or savings on that vacation is irrelevant. Our bottom line only reflects the cost of the trip, not the origin of the cash.

Aside from extremely wealthy individuals, investment income often cannot meet spending needs. Nevertheless, many investors build portfolios to generate yield, which poses both overt and covert risks, particularly in a market with severely depressed interest rates. First, reaching for income amid low rates creates exposure to unique and specific pockets of risk in various segments of the economy. Second, these portfolios needlessly depress their allocations to growth assets, hampering the ability of a portfolio to grow over time, which often results in severe liquidity problems down the line. (For related reading, see: What's a Tax-Efficient Investment for a Large Sum?)

Instead, investment allocations designed for total return—to grow over time and generate income—allow investors to strategically harvest assets from a portfolio. For example, in periods of strong stock market performance, the investor might raise money from the appreciating asset. Unfortunately, investors that succumb to the mental accounting bias can’t fathom ever selling a position. They’d rather assume risk for the sake of monthly cash flow.

Think of a retiree that needs to generate income of $5,000 a month to pay the bills. To successfully do so, she’ll need to assume significant risks without ever capturing real appreciation potential. After 20 years, the portfolio may be worth exactly what it’s worth today. However, after 20 years of inflation, the retiree will need $10,000 per month to pay for the same bills, and she’ll end up needing to cash out principal. Wouldn’t she rather have instituted a well-diversified, total return portfolio that generated some income and actually grew in value over those 20 years?

Unfortunately, without proper guidance, many vulnerable, do-it-yourself investors fall victim to the mental accounting bias and other behavioral flaws. Focused only on how to avoid cracking the nest egg, these investors discount inherent risks and the importance of long-term capital appreciation. In better understanding the downside of inherent human tendencies, investors can begin to redefine reasonable capital needs strategies that reflect financial goals. (For related reading, see: Diversification and Lessons From a Normalizing Market.)

 

Conway Wealth Group LLC is owned by Michael W. Conway, who offers securities and investment advisory services through Summit Equities, Inc. Member FINRA/SIPC, and financial planning services through Summit Equities Inc.’s affiliate Summit Financial Resources, Inc.