Ted was savvy with numbers and kept all his personal finances extremely organized. He was a successful middle class American and had several accounts set up, each with a purpose. There was an account dedicated to saving money to buy his next car, an account for emergency funds, an account for the grandkids, and various investment accounts. Ted was also excellent at establishing a budget. He knew exactly where his dollars were going to go each and every month: how much he was going to save and where it was going, how much his monthly expenses were going to be and how much his payments would be on his debt. He paid the minimum amount due on his new car. He paid double on his 3-year old car with less than a $10,000 balance and paid $1,000 over on his mortgage payment every month. Ted also paid $150 a month on the balance of his credit card. Ted had a plan for every dollar spent or saved during the year, with the exception of his tax refund - that money didn’t count and he used it for whatever.
Ted’s extraordinary organization even extended into his investment accounts. He had an investment account where the goal was taking risk, so that is what he did—every investment was uncertain, but had a lot to gain. Likewise he had an investment account where the goal was to offset the risk in his other account, so all of his money was in “safe” investments. There was one thing Ted never realized. His organization was devastating to his financial future.
In the studies of behavioral finance, there is a bias called “mental accounting.” Which is exactly what Ted fell victim to. He had separated his money by the function of each dollar all the while not considering the logic for his entire financial picture. Unfortunately, mental accounting is like an epidemic. Not everyone may be as extreme as Ted, but the majority of us have fallen victim to it at one time or another. Let’s take a look at the big picture effect of what Ted did.
In one year, Ted’s mental accounting cost him over more than $15,700 in interest, taxes and inflation. If you add the potentially missed investment returns, which we all know are in no way guaranteed, this number grows to more than $100,000…and remember this is just one year!1
How did this happen? We will start with the small stuff. There is that well known thief of your money referred to as inflation. If this is 4% a year that means any money sitting in cash is losing 4% a year. Which was one of the very things Ted was doing... Instead of paying down the high interest loan on his credit card as quickly as possible, Ted was putting $300 aside in cash each month as savings for a car. If his credit card rate is 13%, then coupled with the 4% inflation rate, Ted could possibly be losing $51 a year for each month he tries to save. Ouch! Similarly he is doing this with all of his debt. Rather than looking at his financial picture as a whole with consideration of cash flow, taxes, interest and inflation, Ted was looking at it piece by piece.
The same thing happened with Ted’s investments. He had the right mindset to try to outpace inflation, but the risk was substantial. Part of his money was in an all or nothing strategy and to offset this risk the rest of his money was not even equal to inflation. A Ph.D. study performed by Craig L. Israelsen over a 15-Year period surrounding what is referred to as the “lost decade of returns” (the 2000’s), reveals that taking a diversified position among 12 different asset classes with your entire portfolio puts you in a moderately aggressive position and outperforms any other strategy significantly. 1
Oscar Levant said it best, “What the world needs is more geniuses with humility, there are so few of us left.” The best of us can easily get off track by the ways of this inherent bias we have, but we can’t forget how dangerous mental accounting can be. The key thing to remember is money is money; regardless of where it came from or what it is intended for—it is all the same. This is why we take such a holistic approach in our planning. Frankly, we get really nosy and want to know everything we can so we can help you visualize your entire financial layout and develop the best course for your financial future.
- Assumptions- Savings account for car is 0% interest; Account for grandkids is earning CD rates of 0.5%; New car has a loan balance of $35K at 4% interest for 60 months; Old car loan balance of $10K at 4% interest for 36 months; Mortgage loan balance is $200K for 30 years at 4%; Credit Card balance is $10K at 13% interest ; Tax Bracket is 33%; Inflation at 4%; Safe Investments of $700K annualized return at 3.78% and Speculative Investments of $300K annualized return at 0.66% and Moderately Aggressive Investments (15-year period 1999-2013; Craig L. Israelsen; 7TwelvePortfolio.com)