The Upside of Mental Accounting

Theorists in behavioral finance often discuss mental accounting, the phenomenon in which individuals treat different pools of money differently, as a cognitive bias.  In truth, it can be a problem.  The client who discusses the great return on their stock portfolio last year often neglects to mentally combine it with the rest of their portfolio—which might be 80% in municipal bonds that performed terribly.  Mental accounting allows the client to be thrilled with their return, although the actual return on the whole portfolio may have been negative!

Mental accounting is a natural function, however, and advisors can also use it to a client’s advantage.  One situation in which this is very clear is for retirement distribution portfolios.  During the capital accumulation stage, the client is ideally invested for growth.  During the distribution phase, however, client psychology often changes.  Understandably, they become much more protective of their capital.  After all, they have typically spent a lifetime accumulating it and they won’t be generating any more of it.  The problem, from an investment point of view, is that they often become so risk averse that it is difficult for their capital to earn a return sufficient for them to retire on!

Jeff Benjamin, writing in Investment News, discusses bucket strategies, which are often extremely appealing for retirees:

Using bucket strategies to manage clients’ retirement income has become more popular in recent years and the reason is pretty simple: Dividing a client’s portfolio into separate pools, or buckets, each with varying investment objectives, works.

Source: www.rustytin.com

The basic idea is to separate money for liquidity from money oriented to growth.  Whether the capital is divided into two buckets or six is immaterial.  As an advisor, you are simply harnessing the mental accounting that the client is going to do anyway–and using it for their benefit.

“There’s a psychological appeal of separating a portfolio into buckets, and that’s why people like it,” said Mike Henkel, managing director at Envestnet Inc., a technology platform that helps advisers construct bucket models for their clients.

Although one could argue that the use of buckets is merely behavioral-finance sleight of hand, he and others think that “mental accounting” has real benefits both for advisers and their clients.

The real benefit is that the buckets allow the client to mentally segment their capital, which can allow different levels of investment risk to be tolerated much more easily.  If the client knows their liquidity needs are covered for the next two years, it becomes much easier to resist selling out of equities during a downturn.  The growth bucket, at least in the client’s mind, is a separate entity.

Some advisors prefer simplicity and just use two buckets, one for liquidity and one for growth.  (I have found that clients often find it psychologically helpful to have a buffer, so I’ve tended to use three buckets:  one for liquidity, one for a balanced account approach, and one for growth.)  As the more growth-oriented buckets appreciate over time, small amounts can be peeled off periodically to fund the liquidity bucket.  It can often allow the overall portfolio to continue to grow, while the client is mollified that the liquidity bucket is not rapidly disappearing.

Keep in mind that the point of mental accounting is simply to allow the client to shoulder a more appropriate level of investment risk.  A bucket approach will not save you if the client’s savings are inadequate to begin with.  There is nothing magic about a bucket approach that will cause the capital to grow any faster!  Portfolio growth will be functionally equivalent to whatever the overall asset allocation is without the buckets being considered.  The advisor is not changing the portfolio—they are just changing the way the client thinks about it.

8 Responses to The Upside of Mental Accounting

  1. […] in the crisis were those who divided their money into buckets of differing volatilities.  This is a psychological trick gleaned from behavioral finance—just a different way of looking at the same allocation.  We’ve written about this […]

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