Humans are not rational, particularly when it comes to investing.
Knowing that, is there a way to make this fact work to our advantage as investors? I believe there is.
One of the best documented irrational human tendencies, as it pertains to finance, is engaging in “Mental Accounting”.
Mental Accounting is a behavioral finance concept which deals with the fact that individuals tend to make quite different decisions with their money depending on how it was received, and/or, how and when it will be spent, rather than purely on what is in their best interests.
One example of Mental Accounting is the fact that most people are generally willing to spend more on a purchase when using a credit card rather than cash. This obviously makes little sense when viewed rationally, as the price of the good or service is the same either way. If anything, it is likely to be more expensive on the credit card if one doesn’t pay off the balance each month, and thus, is subject to paying interest. However, for some behavioral reason, individuals feel quite differently about how they spend money using each of these sources.
Another example is the person who is carrying a balance on a credit card, often with interest rates as high as 15%-20%. Yet rather than using their discretionary income to pay down this debt, they choose to put it into a savings or investment account. The thought is that debt is one thing, and investments or savings another, often because we just don’t feel secure without some sort of cash savings or investments. The problem here is that, again, from a rational perspective, they are both part of the same equation. Your net worth is simply the sum of your assets minus your liabilities. They cannot be separated on the balance sheet, only in the mind. Let’s say we put those discretionary dollars into a 3-year CD paying 3% interest, and the rate on the credit card balance is 18%. We are now losing 15% per year guaranteed, but this type of behavior occurs all the time.
One of the most common cases of Mental Accounting we encounter is with tax refunds. Very often, people are more likely to spend their tax refunds on frivolous discretionary purchases as opposed to what they would spend with their regular income. This obviously makes no sense, since money is money, and the origin of those dollars should have no bearing on how they are spent, but humans are human, and for some reason, it very much does.
Almost all of the research out there on Mental Accounting comes to the same conclusion: It is not helpful to our overall financial well-being in the long-run. As a financial advisor, and a numbers guy in general, I wholeheartedly agree with this conclusion. But I also work with real life clients on a daily basis, and as such, have come to understand that the idea of the rational investor is a fallacy, and behavioral finance is undoubtedly real. In light of that, while I am not about to endorse the kinds of detrimental behaviors described above, I have found one area where our Mental Accounting tendencies can be used to an investor’s advantage.
When most clients invest their assets, they do so with one overriding portfolio allocation. They (hopefully) spend some time determining what their risk tolerance is, and whether that allocation ends up being aggressive or conservative, or somewhere in between, but there is generally just one overall portfolio. This is the most common practice and prudent investing has been conducted in this manner for decades.
This one-portfolio approach can, however, lead an investor to make either short-term, knee-jerk mistakes with their long-term investment dollars, or, alternatively, to make unwise long-term decisions for a portfolio, that is unlikely to actually be invested for the long-term. This is particularly true for investors without an advisor to lean on for perspective, or for those who just cannot resist the temptation to make short-term adjustments to their investment plans when markets get choppy, even if they know in their rational minds that it isn’t good for them to do so in the long-term.
As we all know, one of the keys to investment success for most of us is staying invested for the long-run. However, it is extremely difficult for most of us to do so through different market cycles, particularly these days, when we are exposed to so much media onslaught. So is there a way to use our own flawed judgment (i.e. Mental Accounting) to our advantage and potentially change this outcome?
I think so, and I like to call it ‘the three little pigs.’
In order to accept and potentially take advantage of our natural predilection to be irrational, or practice Mental Accounting, I often recommend setting up separate portfolios, with separate allocations, each with its own timeframe and goal. For most people, this would consist of at least three separate and distinct portfolios – let’s call them Piggy-Banks.
With this tiered and segmented approach, people seem to feel more secure and are better able to handle market volatility, because they have a separate and distinct plan and portfolio for each of their time-based goals. By compartmentalizing, or using Mental Accounting for partitioned time-frames and objectives, this approach allows people to make independent, and hopefully, more rational, portfolio decisions for each one.
Here’s how it works:
Piggy Bank #1 – Cash Reserves and Short-Term Needs
Piggy Bank #1 is filled with assets that may be needed in the next one to three years. This is generally your cash reserve position, plus any money you know you will need for near-term expenses such as, for example, home improvements, funding your child’s wedding, or a new car. Additionally, for those already in retirement, and drawing off their portfolio, this is where those supplemental income dollars reside. Piggy Bank #1 mostly utilizes very secure investments that are unaffected by market movements, like bank accounts, money markets, and very short-term CDs. Here, you are sacrificing yield and potential growth for security and peace-of-mind.
Piggy Bank #2 – Money for the Mid-Term
Piggy Bank #2 is filled with dollars you know you are likely to need to access in the mid-term, which I define as in the three-to seven-year range. Again, for those already in retirement, these dollars may be for the supplemental income needed during this time-frame, or for the wedding and/or new car that is slightly further down the line. This portfolio will be invested more aggressively than Piggy Bank #1, due to the additional time until the dollars are needed, but it will still be relatively conservative as compared to Piggy Bank #3. Think Moderate/Conservative to Moderate, with the inclusion of a small amount of equities to go along with some short and medium-term fixed income securities. Here, you are still hedging towards safety, while taking on a bit more exposure to volatility in order to help keep pace with inflation.
Piggy Bank #3 – Investments for the Long-Term
Piggy Bank #3, is the growth engine of the three little pigs, and is filled with the remaining dollars which will hopefully not need to be spent for many years down the line. This portfolio will be invested more aggressively then the two Piggy Banks above, and as such, will experience the most volatility through the years. Knowing that these dollars will not be needed for many years, perhaps even decades, makes it easier for clients to let this portfolio rise and fall with the markets, staying invested for the long-term as planned, and allowing the long-term positive statistics of investing work to their benefit. Piggy Bank #3 leans more towards the Moderate to Aggressive range of the risk tolerance scale and contains a much larger exposure to equities in relation to fixed income securities and cash.
Perhaps as you are reading this, especially if you are one of those few ‘rational’ investors out there, you’re thinking that it all sounds fine, but, at the end of the day, what you’ve got is three portfolios that are really nothing more than the combined allocations of these three buckets of money. And to this rare and rational investor I would say, yes, you are absolutely right. Having different baskets of money does not actually change the risk characteristics of your overall portfolio; however, it is quite likely to change your (irrational) behavior during the inevitable ups and the downs of the markets.
To be clear, this is a purely behavioral strategy, not a statistical one, and so, for most people, having just one overarching portfolio allocation still tends to make the most sense, both from a statistical as well as logistical point of view. That is especially true if you have a trusted advisor to provide support and perspective, and help you identify and avoid the triggers that cause many of us to make reflexive investing mistakes during stressful moments. But for many, who may just need an additional layer of protection against the behavioral biases that haunt most of us at some point or another, ‘the three little pigs’ strategy can be an extremely effective way to provide it.