Have you ever felt that investing can have you feeling excited, worried, angry, sad, and some other emotion all at once?
You’re not alone, nor are you abnormal! Behavioral finance is an area of study that examines the impact of emotion, cognitive biases, and other psychological factors on financial decision-making and hence on financial markets. Behavioral finance emphasizes the role such factors play in irrational investment behavior (e.g., under or overreaction to financial information) and its consequences in market fluctuations (e.g., financial bubbles, panics). Datapoints.com
There is a wide range of concepts covered in behavioral finance but typically the focus is on five main concepts:
- Mental accounting
- Herd behavior
- Emotional gap
As you can see, this is not a simple topic, and would likely take a book to cover not just a blog post.
For this week I’ll cover mental accounting.
Nobel Prize-winning economist Richard Thaler introduced the concept and published a paper titled “Mental Accounting Matters” in 1999 which can be found here if you’re interested.
VERY simply put, mental accounting is the differing value an individual places on the same amount of money.
Money should all be viewed the same, or money is fungible, money should have the same value no matter how it is categorized for use.
Have you ever paid for an item or service and groaned when you had to pay $500 for it? For whatever reason, you were refunded that money and blew it on whatever you had to have at the time.
Paying $500 was an awful expense and you were probably upset to pay it, why was spending the refund no big deal?
Thaler refers to these windfall situations (money you did not expect to receive) throughout his paper, like finding $30 in your jeans, or receiving your tax refund. No matter how the money was realized, it should be viewed the same. As humans, this is not typically how we operate, but with education, we can work to “rewire” our thought processing.
Let’s bring this together and hit our target, an example in retirement funding and mental accounting.
When you leave a job and have a relatively small retirement account, let’s say $5,000, sometimes you forget it even existed. Down the road, you receive a letter in the mail stating that you have the option to roll those funds to another retirement account or cash it out for a “small” fee.
Why not just cash it out and buy something nice since you forgot about those funds, right?
The problem with cashing out those funds is that the fee isn’t so small, and you forgot about it, so why not save it for your future? Cashing it out before you reach the age of 59 ½ will incur a 10% penalty on top of the taxes you’ll pay. If you’re in the 22% tax bracket you’re losing 32% of that $5,000, so you clear $3,400 ($1,600).
Had you rolled those funds to another retirement account which ended up realizing a 5% annualized rate for 20 years until you retire, it would be worth $13,266.
When you withdraw those funds in retirement let’s assume you’re now in the 10% tax bracket, you’d clear $11,939.40 ($1,326.60), so you even paid $273.40 less to withdraw $13,266 vs. $5,000.
Is that a life-changing amount? No, however, through life, we are faced with countless decisions like these, and unfortunately, we make the wrong choice from time to time.
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