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Is There Any Danger To This Tendency Towards Compartmentalization In Our Investing?

We all tend to create “mental accounting” rules about how we will spend and save. These rules can give us round numbers to help make sense of finances, however, over-simplification can be wrong. We talk with Dr. Meir Statman about how this “mental accounting” transfers over to our thoughts on investing, and the dangers of compartmentalization and rigid rules.

Transcript

Tim Maurer:
Hello, Tim Maurer back with another episode of Ask Buckingham, a video podcast designed to bring clarity in the midst of confusion by connecting your great personal finance questions with straightforward answers from industry thought leaders. Today’s question will be answered by Dr. Meir Statman, a consultant to Buckingham and the Glen Klimek Professor of Finance at Santa Clara University, and one of the world’s foremost authorities in the field of behavioral finance, one of my very favorite topics. Here’s the question we’ll be tackling today. Dr. Statman, as investors, we tend to fixate on the performance of our investments in a compartmentalized fashion. We look at what the market did today or last week, last month, and especially last year. While these can be helpful to offer us some perspective, I wonder, is there any danger to this tendency towards compartmentalization in our investing?

Meir Statman:
Having dates and having round numbers to look at is very natural and useful and helpful in our thinking. Just think about dates. We have Christmas on December 25th. Each of us has a birthday. We have anniversaries. It gives chunks of time and chunks of numbers that we can make sense of. If you asked me what the return was from March of one year to February of another, I would not know immediately, but if you asked me what was the overall return in 2008, I’d be able to tell you at least if it was positive or negative, so that simplification works. The problem of course, is that sometimes you get simplified but wrong.

Tim Maurer:
Simplified but wrong, so what is an example when focusing too much on some sort of bite-sized, say investment return, could lead us down an unproductive path, as investors?

Meir Statman:
Well, let me provide something that is not entirely returns. I think about our tendency to separate our money into income and capital. That makes life very easy, especially if we add to that the rule that says spend income, but don’t dip into capital.

Tim Maurer:
Sure.

Meir Statman:
Now, people who are going to say, “Wait a minute, that’s not true. I should earn. You know a dollar is a dollar.” Well, it is very useful for young people. It is useful because it helps in saving, that is now I send some money to my 401k. That is now becoming capital and I don’t touch it until I retire. That works really well.

Meir Statman:
Now, you can see where it backfires on you, and so what you’re going to have are older people, retired people, who have accumulated in fact a whole lot more than they imagine, and a whole lot more than they can spend in a lifetime or two, but they don’t want to dip into capital. People go through all kinds of machinations. “How do I live on zero interest rates, on low dividend yield, and so on?”

Meir Statman:
I wrote an article some years ago about it in the Wall Street Journal, and it was amazing, the kind of responses that I got, where people say, “You really changed my life. I went out and I fitted myself for some expensive golf clubs.”

Tim Maurer:
There you go.

Meir Statman:
People understand, what’s the point of it, that is, here is a rule, a framing that worked for you when you were young and accumulating. Now, relax and spend.

Tim Maurer:
Amazing. Amazing to write an article for the Wall Street Journal and hear people say, “You changed my life,” right?

Meir Statman:
This was a very unique experience. Many times, I get arguments, “No, you’re wrong,” and so on. Here, people wrote. Somebody wrote who is really very wealthy. I checked it, because he sent me an email. I could check on Google. He said, “I’ve been trained this way. My parents told me that you don’t dip into capital and so on. If I wanted to buy something that I considered extravagant, I would take another position on some board to get the money to do that.” He, of course, realized that this silly. I hope that I helped him break a very bad habit.

Tim Maurer:
You did, perhaps. This is a super intelligent, very successful individual. I think that’s another thing to point out here, is that this is one of the ways that we can absolutely almost fool ourselves. Now, is this part of the concept I’ve heard of in behavioral finance and economics, known as mental accounting? Is that what we’re talking about?

Meir Statman:
Well, yes. You put your income in one mental account and your capital in another mental account. We do more of that. There might be a mental account or even a tangible account for rent, for the mortgage payment, perhaps for edification that you’re planning, and so on. You can see how useful it is, because if you have a mental account for Christmas gifts and you have a rule, “Don’t touch that other than for that,” then if you don’t take it out for vacation or entertainment to someone, then your kid will have some Christmas gifts. Otherwise, they’re going to have empty boxes with fancy wrappers and very disappointed kids. If you have an account, a joint account with your husband or wife, and if you don’t coordinate, checks will bounce.

Tim Maurer:
Right.

Meir Statman:
Under some circumstances, it makes sense to have two separate accounts, such that people can keep in mind how much they have, and not get themselves in trouble with the bank and so on. It is really useful, but you can see where mental accounting can get you in trouble when those rules become too rigid.

Tim Maurer:
Yeah. I love that every time we speak, you are finding both sides of the coin of these various biases that have now been illuminated to us through the field of behavioral economics and finance. I find that an awful lot of times, they’re just getting hammered, as though they’re mistakes, as though they’re errors in our DNA, right? They’re faults. I love the way that you point out the positive side of these various biases. Are you often defending these biases?

Meir Statman:
Well, I think that it’s really very important to note that we have shortcuts which are very useful, and then those shortcuts sometimes become errors. If we can distinguish shortcuts that make life easier from errors, then we are fine. For example, if you’re going to renovate your bathroom, there are a zillion contractors who can do that. Well, you’re not going to do that if it’s too complicated.

Tim Maurer:
Right.

Meir Statman:
If you do that, you might get the optimal one, but what you say is, “Let me talk with three contractors. Let me see their work. Let me see if we have some common thinking,” and you go with that. You get a bathroom that may be not as perfect and not as inexpensive, but you get something that is pretty good.

Tim Maurer:
Well, thank you for pointing out both the benefits and the challenges that come from these biases, Dr. Statman, and thank you for tuning into this episode of Ask Buckingham. Dr. Statman has been a regular guest on Ask Buckingham, and I highly recommend you to check out his other segments on the roles of regret, hope and fear in our investing, and my personal favorite, “Why does the pain of market loss feel so much stronger than the joy of market gains?”

Tim Maurer:
Now, if you have another question that you’d like to see us address, you can do so by navigating to the website askbuckingham.com, or by emailing your question to question@askbuckingham.com, or just click in the corner of your screen right now. It will take you directly to the website. Remember, there are no dumb questions. It’s true, but unfortunately there are plenty of really poor answers out there. Our hope is that in giving you straight answers to your questions, you’ll be able to apply that knowledge in pursuit of good decision making. Please follow us, and by all means, ask Buckingham.

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