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Tuesday, August 7, 2012

The Pitfall of Mental Accounting

The majority of investors have a bucket list when it comes to money. They separate money into buckets and prioritize those dollars usage. An example of this behavior is a college fund. When investor puts the dollars into the college fund they lock it up and wouldn’t consider any other usage of those dollars, even if those dollars were being eroded by inflation they would stay in the college fund bucket. This is commonly referred to as mental accounting.

Mental accounting creates a disconnect with the big picture overview for financial decision making. We are much more likely to take risk with money perceived to be “house money” as is witnessed by the casino behavior with winnings. By example, when we go to the craps table with $100 and win an additional $200, we are more likely to take a bigger risk with that $200 then we would if the money was our own to begin with. The perception is that the money isn’t really ours and we didn’t work to earn it so we can risk it with impunity.

Where this disconnect displays itself best however is with tax returns. Our tax return represents money that we worked for and earned yet we ultimately perceive it as found money and are willing to frivolously spent or risk it. It is not the same circumstance as the casino effect but it is the same result.

So how does mental accounting endanger an investor as a potential victim? The psychological trigger used by scammers is a twist in the mental accounting behavior practiced by individuals. The twist is in the offer of tremendous gains, when triggered the individual reverses the fear of loss to the gain and not their initial investment. The mental accounting fast forwards to the gain and sees it as the risk involved. When the con explains how you will earn 3 million dollars on the upside, he has triggered your mental accounting to the gain. Now the impact of investing $100K seems very reasonable and the fear of loss is focused upon $3 million. The sense of urgency is created and the initiation of personal greed has blinded the victim from the real fear of loss which should be focused on the $100K being risked. This twist of mental accounting is one of the common triggers used in scams, fraud and predatory sales tactics.

The take away here is that money is always just money. It doesn’t come in separate categories such as found, house or risk free. It is a financial means to an end and has stated value. The opportunity to increase and multiply through risk is a transactional event that needs to be fully vetted for due diligence and risk analysis. In the end though the money requires no mental accounting.