Imagine you're walking down the street and stumble across a $100 bill...
You look around to see if anyone is searching for this money. No one is. So you decide to keep it.
But how to use it?
Most of us would choose to spend it – almost right away. We'd take our spouse out for a nice dinner, buy some lottery tickets, or purchase a wish-list item that we've been eyeing for a while.
Now, let's say you get an extra $100 from your employer because you worked on a holiday. In that case... most people would hold onto it. It will go straight into a savings account or into an investment account.
Why do we spend the $100 we found on the street differently than the extra $100 we earned at work?
The answer is because of a behavioral bias called "mental accounting": treating money differently based on its intended use or where it came from. And it could be hurting your investment results...
Economist Richard Thaler, who developed the concept of mental accounting, once ran an experiment where he asked a group of people two simple questions. Here's the first question...
Imagine that you have decided to see a movie and have paid the admission price of $10 per ticket. As you enter the theater, you discover that you have lost the ticket. The seat was not marked, and the ticket cannot be recovered. Would you pay $10 for another ticket?
Only 46% of the participants told Thaler they'd buy another movie ticket. Most said they'd skip the movie and go home.
He then asked this question...
Imagine that you have decided to see a movie where admission is $10 per ticket. As you enter the theater, you discover that you have lost a $10 bill. Would you still pay $10 for a ticket to the movie?
Thaler found that 88% of respondents – nearly twice as many – said that they'd still buy the movie ticket.
On a logical basis, these two answers are wildly inconsistent. In both scenarios, you're down $10. So the answers to both questions should be the same.
However, because of the mental-accounting bias, we tend to categorize our money into different buckets.
According to Thaler, we view going to the movies as a transaction in which we exchange the cost of a ticket for the experience of seeing a film. Buying a second ticket makes the movie seem too expensive, since a single ticket now "costs" $20. In contrast, since we don't post the misplaced cash to the mental account of the movie, we're still fine to spend $10 on a ticket. Fascinating, isn't it?
Most of us are guilty of mental accounting... especially with our investments.
We place a different value on money that we inherit versus money that we earn from our jobs. We place a different value on cash from tax refunds and end-of-year bonuses versus the cash in our 401(k)s. As a result, we invest money differently...
Many studies have shown that people tend to label additional income either as "regular income" or as a "windfall gain." Folks are more likely to spend or aggressively invest windfall gains compared with regular income.
You'll often see investors use their end-of-year bonuses to buy something speculative like cryptos. It's money that you were not expecting, so you might as well have some fun with it and gamble, right?
We also mentally label money based on its intended use. For instance, you've probably said this once or twice in your life: "It's only my play money."
When investors put "play money" into the markets, they often throw out all their normal investment rules – no protective stop losses, no sensible position sizing, etc...
Your money is your money. While it's fine to set aside part of your wealth for speculations, that doesn't mean you benefit from throwing it carelessly away.
It's never too late to make some changes to how you perceive your money...
Always remember, every dollar in your possession has the same value regardless of its origin or how you intend to spend it. Losing $1,000 in the stock market is the same as spending $1,000 to fix your car's transmission or losing a $1,000 wad of cash on the street.
To overcome the mental-accounting bias, a great strategy is to follow an asset allocation. Set aside the biggest portion of your portfolio for safe, blue-chip stocks. The rest you can divide between cash, bonds, chaos hedges, and a small amount of speculations...
By following a specific asset allocation, you can avoid the trap of the mental-accounting bias. If you're already up to your allocation limit for speculations, for example, you won't blow your next end-of-year bonus as "play money."
The important thing is to establish a framework and stick to it. That way, you'll keep your investment goals on track and invest your money wisely – however you got it.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig
Editor's note: When inflation and rate hikes took over, the top investment strategies of the past decade-plus turned upside down. But now, these changes are quietly generating the best income yields we've seen in years – in quality, low-risk stocks. So, Doc Eifrig is stepping forward with a plan to profit... one that has nothing to do with options or any complicated techniques. He's even giving away a FREE recommendation to walk you through it... Check out the full details here.
"Everything you hold today, you essentially decide to 'buy' anew each and every day," Doc says. If you forget this important fact, your portfolio might end up cluttered with poor performers. But a simple step can help... Read more here.
"Not every single dollar you have needs to be in stocks or bonds," Doc writes. Another asset should make up an important part of your portfolio. It's critical to your peace of mind. And until you look at the numbers, you might not realize what a difference it makes... Learn more here.
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