Even a CERTIFIED FINANCIAL PLANNER’s® (me) brain is wired to make money mistakes.
More often then I like to admit, as in daily, I’m making financial decisions that don’t make sense. You probably think someone that writes and talks about financial planning all day, could easily avoid these mistakes. However, it’s a little harder than that.
The purpose of this post is to define two different financial mistakes, that I and many others make daily, without even knowing.
# 1 – Mental Accounting
Definition: The tendency to value each dollar differently depending where it came from (tax refund, inheritance, salary, bonus, gambling winnings), where it’s kept (sub-savings accounts, PayPal, cash), and how it’s spent (term invented by economist, Richard Thaler).
Example of Mental Accounting: I inherited a small amount of Banco Popular (BPOP) stock, when my Grandpa passed away. At the time he passed, the stock was worth around $25. Today it’s worth $3.15. Even though it’s worth far less today, I can’t get myself to sell it. I know it’s the right thing to do because I don’t know much about the company. However, I still can’t sell it because I’ve accounted for it as “Grandpa’s stock.”
Another example is that I have a personal PayPal account, which is funded by anything I sell on eBay. I view and spend my eBay winnings differently than I spend my earnings from Gen Y Wealth. Rationally, I should value these dollars evenly, but I don’t. (Technically, I should even place a far higher value on my PayPal earnings because those are after-tax.)
Treatment: Filter all income, no matter the source and amount, into your primary savings account immediately. Once the money is in your savings account, calculate how many hours it would take you to earn that amount including taxes.
For example, you received a $1,000 tax refund and made $20 an hour this past year after taxes. That $20 tax refund is equivalent to working 50 hours.
Last, wait 30 days before you spend that money.
You can also use mental accounting to your advantage. When saving for goals, use sub-savings accounts. For example, I’m saving for a trip to Peru right now. In my ING Direct account, I have an account nicknamed Peru. I’ve mentally accounted for this money as money for travel. I couldn’t imagine spending it on anything else.
# 2: The Sunk Cost Fallacy
Definition: Sunk costs are expenses and resources, such as time, that can’t be recovered. The sunk cost fallacy is when you let previous sunk costs, weigh in on future decisions.
Example of the Sunk Cost Fallacy: Three months ago, you spent $2,000 fixing up your old car. It ran great for two weeks and then proceeded to break down again. This time it costs $3,000 for repairs.
Rationally, the $2,000 you put in previously, should not weigh into whether or not you should put $3,000 more into the car. That money is gone. Although, according to the sunk cost fallacy, you’re more likely to get the car repaired, knowing that you just spent $2,000 on it.
Another example is the stock I own in Banco Popular. It shouldn’t matter that the stock was worth $25. Right now an efficient market values that stock at $3.15. The money lost by not selling the stock is sunk. The sunk cost fallacy, tells me to hold on to that stock until I get my money back, which I’m guilty of.
Treatment: The easy answer is to not make decisions in the past, make them in the present. That’s easier said than done. So here is some tactical advice on how to accomplish that.
First, ask for help. If your car keeps breaking down, ask a friend or family member what they think. If three people tell you to junk the car, that’s probably the right decision.
For large financial decisions, pay a fee only CERTIFIED FINANCIAL PLANNER® for an hour of their time to review your choices. It’s a small cost to prevent large mistakes.
To avoid having the sunk cost fallacy affect your investments, don’t watch investment news and rarely check your portfolio. In order to have this hands off approach, you need to passively invest.
Personally I login to my investment accounts once a month. You can extend that if you like. I have known people who check once a year.
Conclusion
In the comments, explain a time when you fell victim to mental accounting or the sunk cost fallacy. Looking back, what would you do differently now?
{ 15 comments… read them below or add one }
You make some very good points here RJ. I especially liked that you pointed out that we often make decisions today based on decisions we made the past.
When I was younger, I always enjoyed getting a tax refund. In my mental accounting, I took that as a win because I could do whatever I wanted with that money. It was like a bonus. Today, I’ve come to understand that it is better to break even and not receive a tax return. I’d like all my money upfront, instead of letting the government hold on to it for me. I can use that money to pay down debt right away, as opposed to a few months from now.
@Shawn G – Great Shawn. If you think about your tax refund logically, you wouldn’t loan money to a friend when you’re in debt. So why would someone want to loan in the the Government?
When you say some folks only check their investment accounts once a year, is that assuming they have set up an automatic scheduled contribuition each pay period/month? In otherwords, they can contribute without looking at how their portfolio is doing. I wouldn’t think contributing once is a year/quarter/etc is the best strategy?
Yes…That means logging in once a year, not investing once per year. Most people can’t afford to make one lump sum investment per year, they dollar cost average a percentage of their income.
However to expand a little, if you’re able to say max out a IRA at the beginning of the year it does make sense to only invest once per year. This way you give your investments more time to compound. Does that make sense?
Yep, I get it. So then, since you brought up IRAs, I was curious…can an investor max out a Roth IRA and Traditional IRA both in the same year, effectively investing $10,000 in those two accounts? Perhaps using different risk strategies for each IRA, kind of like teaming up John Stockton and Karl Malone in NBA Jam for the Sega Genesis. Stockon shoots the threes and Karl Malone gets the rebounds and dunks!
In the past, I’ve definitely been guilty of using my tax refund for reckless spending, leaving me with nothing to show for it. I can chock this up to thinking about the money like it was a government stimulus check rather than my own hard earned cash being refunded to me. Oh well… I’ll consider it a life lesson.
Pat S.
@Jonathan – Haha…Unfortunately no. One can’t max out two IRA’s. You can split your contributions up. For example, you can invest $2,000 in a Roth and $3,000 in a Traditional.
Your best bet is probably to look at your 401(k). Contributing as much as you can to both a 401(k) and IRA is like the combination of Larry Johnson and Alonzo Mourning, which beats the Utah Jazz any day.
You are right up my ally with the way you think. I am happy to see you are incorporating Behavorial Finance. The two topics you discussed are the foundation for Behavorial Finance. Again, keep up the great work!
Thanks Ornella. Any other areas on behavioral finance that interest, that you would like to set covered here?
I think it would be great if you discuss about “Anchoring.” I have written about this topic. It’s a great topic to incorporate “sales” and spending more money then intended.
@Ornella – Funny you say that. I touched on anchoring in the first version of this post then decided to edit it out. Plan on writing it in the near future. Good luck with your blog.
Amazing article. Both of these things, people do a lot. In economics, I study that you should only consider marginal costs. So, when you are making the decision about whether or not to spend $3000 for the repairs, the previous $2000 that were spent shouldn’t be considered. If you do consider them (as many people do), your decision won’t be the most efficient one possible.
My friend bought a used BMW and had to spend a few thousand dollars fixing the car up. These were unexpected expenses, but he had already spent thousands by buying the car and couldn’t bring himself to sell it. I’m not sure if he should have sold it or fixed it, but he didn’t even want to consider the option of selling it.
Amazing article. Both of these things, people do a lot. In economics, I study that you should only consider marginal costs. So, when you are making the decision about whether or not to spend $3000 for the repairs, the previous $2000 that were spent shouldn’t be considered. If you do consider them (as many people do), your decision won’t be the most efficient one possible.
My friend bought a used BMW and had to spend a few thousand dollars fixing the car up. These were unexpected expenses, but he had already spent thousands by buying the car and couldn’t bring himself to sell it. I’m not sure if he should have sold it or fixed it, but he didn’t even want to consider the option of selling it.
Ah, the “Sunk Cost” fallacy — also known as “throwing good money after bad.” This is a tough mental stumbling block. It helps to repeat the mantra: “Cut your losses!”
sunk cost is not real cost…..you have it if you wan it to include to your calculation…..this cost is still on debate by academic and profesional in cost accounting………