The Damage Mental Accounting Can Do Today

This is the eighth the Behavioral Finance and Macroeconomics series. We will explore the effect behavior has on markets and the economy as a whole--and how advisors who understand this relationship can work more effectively with their clients. (Access previous articles here.)

Mental accounting describes a person's tendency to code, categorize, and evaluate economic outcomes by grouping assets into noninterchangeable mental accounts. A completely rational person would not undertake this psychological process because mental accounting causes people to take the irrational step of treating various sums differently based on where assets are mentally categorized.

For example, categories could be based on the way that a certain sum has been obtained (work, inheritance, gambling, bonus, etc.) or the nature of the money's intended use (leisure, necessities, investment etc.).

At the end of the day, money is money, regardless of the source or intended use.

At the macro level, people tend to categorize their money into two broad accounts: risk-on accounts and risk-off accounts. Most people will keep a portion of their savings in very safe securities designed mostly to preserve capital, like cash and high-quality bonds. That's a person's risk-off account. People will allocate a separate portion of their capital to risky assets because most people aspire to a higher standard of living; that's someone's risk-on account.

During a period of long-lasting prosperity, such as the period from 2002-2007 or from the 2009 market bottom onward, the fear of a major market drop diminishes. Consequently, people tend to allocate more to risk-on assets and less to risk-off assets.

This phenomenon took hold during the 2005-2007 period, because people believed prosperity was going to go on indefinitely. Investors were demanding high returns, and companies took on more debt to increase their returns. Because of this boost in leverage, profits increased and markets continued to rise. Eventually, though, the music stopped. When it did, leverage led to margin calls, which led to a massive financial crisis. The portfolios of individual investors declined, they panicked and sold their risk-on holdings, and markets dove even further in a self-reinforcing negative cycle.

As we know, the markets eventually recovered, and we are where we are today--in another multiyear bull market. And today, the same thing is happening: Investors are taking on more and more risk. Will we experience another 2008?

The best advice, of course, is to keep your clients allocated according to their investment plan. Investors who simply stuck with their plans (if those plans were appropriate in the first place) and simply rebalanced during the 2008-2009 crisis are fine today.

As we have discussed, people have a tendency to want to lower their risk allocation during market downturns and increase it when markets have rebounded. This action reduces returns. As an advisor, keep your clients on track with their proper allocations and rebalance as market conditions warrant. That will ensure client satisfaction and solid long-term investment results.

The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.