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The Self Deception of Mental Accounting

The Self Deception of Mental Accounting

21 Nov 2019

Consider this: the Smith household comprises two adults, John and Mary. As a couple they run their credit cards so that at the end of each month some $2,000 is left as a debit balance on which they pay 20 per cent p.a. interest. As a separate exercise, the couple prides itself on having a savings jar in which they have $1,000 as a steady balance.

It’s been this way for several years now; in the past 3 years, they have forked out $1,200 in interest to the card company. They have earned no interest on the money in the jar.

If John and Mary had used, say, $800 of their jar money to reduce their card balance in year one, they would have reduced their interest bill by 40 per cent (and still have had a couple of hundred dollars for quick access if needed).

However, they didn’t do it because of an odd behavioural tic called ‘mental accounting’. This is the practice of segmenting money into different ‘buckets’ (one for this, one for that, one for the other). It’s a behavioural trait that many people use without realising it is usually self-defeating.

If the practice was limited to a few hundred dollars of interest, so what? But it’s not. The downside of mental accounting (bucketing) can deplete a family’s investments by scores of thousands of dollars.

What’s the solution? First, should be the recognition that money is fungible – no matter where it is stored or invested, it is still money and the smarter it is allocated, the better the wealth effect. Second, overall wealth is what constitutes financial well-being, and having a bit stored here and another bit stored there is a highly inefficient way to grow and protect one’s funds.

Don’t let mental accounting limit your growth.

Key Points

Imagine bucket A contains $200, bucket B $1,800, and C contains $8,000.

Simplifying Mental Accounting

Simplifying Mental Accounting

The total is $10,000, yet most people treat the buckets separately and apply different psychological values to them; for example, they happily use A to pay for everyday expenses, B for mid-term goals (holidays, etc) and C for long-term goals such as retirement. That part makes sense but what doesn’t make sense is how they might be invested. In most cases, funds in A will earn next to no yield, B a modest yield and C will earn whatever its underlying asset allocation produces.

However, the contents of B & C could be combined and invested in the same way in order to enhance overall wealth (ignore for the moment the tax benefits of C if in a superannuation fund).

If B was invested in a similar portfolio to C, it is likely that total wealth would grow far faster than when separated out.

‘Bucketing’ assets, especially where larger sums are involved is usually counter-productive.


Disclaimer & General Advice Warning

This publication has been prepared by Joseph Palmer & Sons (ABN 29 548 490 818) an Australian Financial Services Licensee (AFSL 247067). Whilst the information contained in this publication has been prepared with all reasonable care from sources, which Joseph Palmer & Sons believes are reliable, no responsibility or liability is accepted by Joseph Palmer & Sons for any errors or omissions or misstatements however caused. Any opinions, forecasts or recommendations reflects the judgment and assumptions of Joseph Palmer & Sons as at the date of publication and may change without notice. Joseph Palmer & Sons, their officers, agents and employees exclude all liability whatsoever, in negligence or otherwise, for any loss or damage relating to this document to the full extent permitted by law. This publication is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Any securities recommendation contained in this publication is unsolicited general information only. Joseph Palmer & Sons are not aware that any recipient intends to rely on this publication and are not aware of the manner in which a recipient intends to use it. In preparing our information, it is not possible to take into consideration the investment objectives, financial situation or particular needs of any individual recipient. Investors must obtain individual financial advice from their investment advisor to determine whether recommendations contained in this publication are appropriate to their personal investment objectives, financial situation or particular needs before acting on any such recommendations.

Author: Eddie Lees

Categories: Palmer Blog, Special Insights

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