Chapter 4

Mine, all mine (mental accounting)

I was once asked to explain the most important things that drive investment success, but my questioner added that he did not want to hear about controlling his emotions. From the qualifier in his question, everyone will instantly recognise that my interlocutor was in denial about the need to work on this aspect of his investing activity. Indeed, it is easy to see that this investor was in the second of the three stages investors go through in becoming proficient. I learned these three stages from market wizard and trading coach Van K. Tharp. His take on them focuses strongly on the idea that the path to investment and trading success lies within us.

In the first stage beginners look for tips — what to buy and when to buy and sell. They are looking for a guru who will tell them what to do. They are seeking the solution to the investment problem outside themselves. What they need to do is progress to the point where they realise that the questions they are asking are trivial and that they are more likely to succeed as investors if they learn to make their own decisions.

In the second stage neophyte investors come to realise the need to learn to make their own decisions. This is when they begin their search for the perfect system. Most of this search revolves around finding the method that will enable perfect decisions on which stock to buy and when. Usually, beginners will try many systems that they have read about in books or have learned about in many seminars. None of the methods they try will lead to profitable results all of the time. The reason for this is that there is no perfect system that does not make losses on some investments, so their search for one is ultimately futile. The problem is that their search for the perfect method is still an exercise in looking outside themselves for the solution.

In the third stage those investors who have stayed the course gradually gain an understanding that the path to successful investing lies within us. They appreciate that investing results depend on how we make decisions rather than on some external system. In other words, they realise that their profits or losses are created by their actions and that they can change what they do to improve their performance.

Since investing success depends on the quality of our decisions, to make good decisions we need a set of rules and guidelines in the form of an investment plan, and the discipline to follow those rules and to exercise sound judgement when applying guidelines. Our investment plan will have rules and guidelines for when to buy, when to cut losses, when to take profits and how much money to commit to a single investment. How disciplined we are in following these rules and guidelines depends upon whether the plan is aligned with, and compatible with, our knowledge, skills, experience, beliefs, risk tolerance and general personality. Most important of all, it depends on our decision-making skills, otherwise we may think we are following our plan perfectly when we are actually doing a poor job of it.

This suggests that investing is really an activity that is played out in our mind. Our investment results flow from how well we manage our emotions and avoid cognitive biases in decision making. Avoiding cognitive biases is first a matter of coming to a realisation that they exist and that they apply to us.

Many beginners do not even know that these problems exist. As they become aware of them, they have also to get to the point where they admit that these issues apply to them personally, just as a problem drinker or problem gambler has to recognise that they personally have a problem. Until they get beyond the denial stage, investment success will remain outside their grasp.

If you are tempted to think you are not in denial about some issues, ponder the reaction I got to a presentation I did to the Australian Technical Analysts Association annual conference in 2000. I presented Terrance Odean’s research on overconfidence. The inescapable conclusion was that while both men and women tend to be overconfident, men are measurably more prone to be overconfident in trading than women. In the feedback from the mostly male audience I was rated the speaker they most wanted to hear again, but emphatically they said they wanted me to talk on a different topic. Clearly, they were in denial about, and therefore did not want to hear, the message I was giving.

In his book Mindtraps, Roland Barach outlined 88 common ways in which we all sabotage our investment success through the way we think about investing. Barach stresses that these mind traps are not due to low intelligence, because the smartest investors are just as susceptible to them. Instead they flow from cognitive biases in the ways in which we make decisions.

One of these cognitive biases is called mental accounting. It happens because we mentally put things into categories so that we can deal with the complex world in which we live. It simplifies things. This is very useful in many ways, especially in controlling expenditure against separate budgets, and is commonly used in business and personal finance. However, it can also lead us into making poor decisions because we may be blinded by the way we have defined things.

This definition of things into categories or accounts, which is, like many common heuristics, a useful way of dealing with many problems in life, can also lead us into a cognitive bias. In mental accounting, we take things that are identical and split them into two or more mental accounts. The result can be that, although what is in each category is identical, we now regard it differently in our minds. This mental accounting is very common and can be particularly pernicious in investing.

Economist Richard Thaler gives a good example of this process. Imagine that a married couple are saving to buy a holiday home in five years’ time. The $100 000 they have saved so far is accumulating in a savings account at 4.5 per cent interest. Then their old car breaks down and is not repairable, so they need to buy a new one. They finance the $25 000 dollar cost with a loan at 9 per cent.

When it is presented like this, and we are not personally and emotionally involved in the decision, we can see the apparent stupidity of this decision. Clearly, the couple should use $25 000 of their savings, which costs them only 4.5 per cent in interest forgone, and deposit the repayments they intend to make on the car into the savings account. If at this point you find yourself wanting to defend the decision the couple made, you are probably in denial on this cognitive bias, so read on.

The reason they do not use their savings is at least partly because they have categorised the money in the savings account as ‘holiday house money’ and the money they intend to apply from income to car repayments as ‘car money’. However, this is entirely a mental construct. Clearly each dollar is the same as every other dollar.

Of course, the couple may rationalise the decision by explaining that they may have difficulty maintaining their self-control. They may find that once their savings are spent, they will be tempted to spend the intended repayments money, rather than saving it. That this is a rationalisation to protect their mental accounting is abundantly clear when we consider that the same mechanism they use to save now for the holiday house money, say a direct debit of salary to the savings account each month could be applied to the repayments money. If they have the discipline to save for the retirement home, then they would have the discipline to save the notional car repayments into their savings account for the holiday home.

Categorising or labelling money into categories or accounts causes people to perceive it differently in different circumstances and so to act illogically. Once we realise that money is fungible, which means that every dollar is the same as every other dollar, we can start to overcome the mental accounting bias and make sounder decisions.

I see the mental accounting bias played out in the markets all the time, with people talking about taking greater risk with some money than other money. We have all heard people rationalise their taking on high risks by saying that it is ‘money I can afford to lose’. Just think for a moment about this. If they have money they ‘can afford to lose’, then they must also have money they ‘cannot afford to lose’. However, as we have just seen, money is fungible, so they are treating some money differently to other money in order to rationalise poor investment behaviour.

The other example I come across frequently is people who take greater risk with what they call ‘the market’s money’. This is well known in the world of casinos as ‘house money’. This is a very common example of mental accounting that is not even recognised consciously by most gamblers.

I sometimes teach how the application of simple ideas about what a trend is should always save us from being caught holding stocks that ‘crash and burn’ (ABC Learning Systems, Allco, and so on). I do this by putting a chart on the screen. I ask the audience to assume that they own the stock. In most of the situations there is a good uptrend leading into the first chart. From there, the chart begins gradually to deteriorate. They are to tell me when they would sell, as I show them how the price action unfolded.

Before long someone will comment that it would depend on the price that he or she paid for the stock. This investor takes the view that, if there is a good profit there and only part of it had been given back on the move down from the top, it is different to the situation in which there is already a loss on their investment. What the investor is saying is that when he or she is playing with ‘the market’s money’ it is quite different to the situation where the investor is losing his or her ‘own money’.

This is a good example of where there is more than one way of looking at a situation. The novice investor looks at it as I have just described. The successful investor looks at it entirely differently. Both would agree that the investment task is to utilise money in their investment account to make profits. One way to do this is by buying a stock and selling it later at a higher price.

Let us say that Cathy and Simon both buy a stock at $1.00. It rises to $2.00. At this point we ask them both what their profit is. Both say that it is $1.00.

Cathy sells at $2.00. Tom waits a while and the price goes down. He sells at $1.80. We ask them again what their profit is. Cathy says $1.00 and Tom says 80¢.

We put it to Tom that, since we asked him the first time, he has lost 20¢. No, he says, I didn’t lose anything — it was only ‘the market’s money’. He cannot see that he is redefining his profit from when we first asked him.

To see the point here, consider that instead Tom had bought the stock at $2.00. When it went down to $1.80, he sold it at a loss. He would then agree that he had lost 20¢. However, the situations are exactly the same: he did own it at $2.00 in the first situation and he sold it at $1.80. However, because in the first case he had categorised his unrealised profit as ‘the market’s money’, he did not see that he had made a loss when the price fell from $2 to $1.80.

The important insight here is that we need to understand the many subtle ways in which we can unconsciously sabotage our investment results through cognitive biases. The successful investor is one who knows that their paper profits are their money and should be protected just as diligently as they protect the money that they took out of their bank account to make the investment in the first place.

Many years ago, I read somewhere about a trader who, when he made a big profit, forced himself to put it in his bank account and not trade it again until he had got used to owning it! The same point is being made — that the profit was his, but there was a temptation, just as for a gambler in a casino, to take less care and greater risks with the ‘house money’.

Summary

Investing success depends on the quality of our decisions. We mentally put money in categories or accounts in order to simplify problems. This is one manifestation of what is called mental accounting. In investing, common categories, or mental accounts, that we create for ourselves include ‘money I can’t afford to lose’ versus ‘money I can afford to lose’ and ‘my money’ versus ‘the market’s money’. Successful investors take ownership equally of all the money that they invest, including unrealised profits.

Strategies

1 Revalue every investment regularly to its current value if it was sold today. Do not focus on the price you paid or the amount you invested. Set up your records to make the price now and the current value far more prominent.

2 Each year, start your records again, taking the price and value of each holding at the end of the previous year as your cost. This helps you to accept that the gains made are really your money. If the price then falls in the new year, it will seem more like a loss and you will guard it more carefully. It also helps to orient your thinking towards this question: For how long does the price of your stocks have to go up before you take ownership of the gain? If you bought a stock 10 years ago for $1.00 and it is now worth $5.00, when does the $4.00 gain become your money?

3 Plot the total value of your portfolio daily or weekly on a graph so that you can see the level it has reached and how much it has fallen from the previous peak.

4 Take some profit off the table from time to time. I have a guideline that when a stock I buy doubles in price, I sell half of it, which takes my profit off the table and lets my original investment continue to run. There are other reasons for doing this relating to rebalancing the diversification of the portfolio, but it also helps to counter the mental accounting bias that unrealised profits are ‘the market’s money’ not ‘my money’.

5 Write a report on your total portfolio every six months. Start with what the total portfolio was worth at the start of the six-month period as ‘My Opening Wealth’. Add dividends and imputed credits received/accrued. Add/subtract capital gains/losses. This will give a total, which you label as ‘My Closing Wealth’. This will help you feel that all of the present value of your portfolio belongs to you and none of it to the market.