Behavioural finance and the illogic of ‘mental accounting’

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Several aspects of investing are known and well understood. Invest for the long-term with a well-diversified portfolio that is custom made for your financial objectives and risk tolerance.
Several aspects of investing are known and well understood. Invest for the long-term with a well-diversified portfolio that is custom made for your financial objectives and risk tolerance.

This column is the third discussion in the three-part series on behavioural finance, dealing with the pitfalls of human behaviour and investing.

We all invest with confidence and enthusiasm and no matter how diligent we attempt to be, human behaviour gets in the way and causes us to make “human” mistakes.

Most investors realize how important it is to diversify an investment portfolio. Investment theory shows the importance of diversification.

A successful portfolio that is well diversified is likely to provide the investor with a higher return, with lower risk, than if diversification was not used. Many investors appreciate the importance of diversification.

Holding many different investments means some years some investments will do better, or worse, than other investments you own. That is normal and should be expected.

Financial theory suggests you consider all your investments as one portfolio and evaluate the performance of your portfolio as a single entity, as opposed to the diverse component parts.

Sounds logical. Logical yes, however in reality something different happens.

Assume you had purchased several investments in equal amounts. At the end of the year one investment had appreciated by $6,000 while another lost $5,000.

Human behaviour research suggests the investor is likely to dwell on the $5,000 loss despite the fact that another equal sized investment appreciated by $6,000.

This illogical thought process is referred to as mental accounting, and takes the focus away from the overall portfolio and the advantages of diversification.

Some investors might misuse this information and adjust their investment portfolio in a harmful way. They might be inclined to sell the investment that lost and use those funds to increase the investment that had appreciated.

That would be fine if last year’s investment performance was an indicator of next year’s performance, however, that is far from the truth. There is little correlation between investment performance from year-to-year.

The risk of investing is you do not know the results in advance and have no way of predicting them accurately. You can use investment theory and logic combined with good judgment, but in the short term investing is not predictable.

Several aspects of investing are known and well understood. Invest for the long term with a well-diversified portfolio that is custom made for your financial objectives and risk tolerance.

That is the formula for success. Some call that evidence-based investing which means use what is known about investing to develop your own personal investment strategy.

Over managing your investment portfolio by focusing on short-term winners and losers is a human characteristic that you will hopefully recognize, and not allow to encourage you to make short-term, reactive, decisions.

The common theme of the last three columns is that the study of behavioural finance can help us all better understand how human behaviour can make us poor investors.

My recommendation is to understand the fundamentals of investing as well as to appreciate, and try to avoid, the human tendencies that can hinder your personal long-term investment performance.

Since 1991