How to benefit from mental accounting

If you’re looking for a market edge, behavioural finance provides some insight, specifically the concept of mental accounting.

Mental accounting attempts to explain “how our minds value different things […] and how this impacts our behaviour,” says a Richardson GMP market insight report. The phenomenon explains why we’re more likely to label money depending on how we earned it, what form it’s in (such as cash versus credit) and how we bucket it. For example, people are more willing to gamble $10 if it’s given to them compared to if it’s earned.

The concept also applies to investment capital. “A popular scenario is when investors take the winning proceeds on a trade and invest more aggressively with it, treating the gains as free money compared to money earned and saved,” says the report. “What really matters is the whole portfolio, not the profit or loss on an individual trade or bucket of money.”

Read: Save clients from emotional mistakes

Investing opportunity

Richardson GMP has identified a way to benefit from mental accounting in its fund based on behavioural finance, by targeting it during company spin-offs. Mental accounting comes into play when an investor or portfolio manager who owns the parent company receives shares of the spin-off.

“Depending on the size of the spin-off relative to the parent, this distribution can often be viewed as free since you never explicitly paid for it,” says the report.

Indeed, the firm’s research shows that investors treat a spin-off as a function of its size relative to that of the parent company.

“Notably, when the size of the spin-off position is materially smaller than the parent, it creates a perplexing problem for the investor,” says the report, which explains that investors are now in a triple-threat position. They can continue holding the relatively small position of the spinoff, complete due diligence and build a more meaningful position or sell it. Most investors choose the last option.

When analyzing such relatively small spin-offs over the last few years in the U.S. market, the firm found that shares typically see strong selling pressure on high volume, once the spin-off is complete, as investors ostensibly blow out their small positions.

“After a number of days, this selling pressure and volumes often stabilizes, allowing the share price to recover,” says the report. “This creates an opportunity to buy during the weakness and wait for the shares to normalize.” (The firm notes that this explanation of its fund’s strategy is a simplified one, since the strategy incorporates additional factors.)

For more details on the firm’s mental accounting research, read the full Richardson GMP report.

Mental accounting and goals-based investing

On the positive side, mental accounting is in part what makes goals-based investing effective, wherein different portfolios are used to reach different goals, all with various return requirements and risk profiles.

Read: Your guide to goals-based investing

In a blog post, Don Nalls, principal at Nalls Sherbakoff in Tennessee, says this bucket approach has crucial differences for investors compared to the negative examples of mental accounting. For example, the approach helps cautious investors feel more comfortable taking on the risk required to reach their goals, “since the most important goals are assigned the safest investments, whereas less aspirational goals may allow for investments with a higher risk and return profile.”

Further, Nalls says that, by having all goals clearly articulated, it becomes easier to determine what to do in the event of an unexpected windfall.

Read Nalls’ full post.

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Clients with mental health issues at risk of poor financial decisions