Investing money is a topic that I try to stay away from myself. Why? Because I've always focused on personal and microfinance, to the extent that I don't think I should be giving you any advice. I do have investments myself, but those I have been adviced on, so again, I'm not the source of information you want. I also don't call myself a behavioural financier for that reason, I am safely sticking to my behavioural science meets personal finance domain. Luckily, there's others who do dive into finance and behavioural finance plenty. Our author today for example, does so: Lachezar Ivanov is an Evolutionary Behavioral Scientist and a PhD Candidate at European University Viadrina in Germany. He is also the founder of Advertising Agency & Consultancy Evolutionary Inc. Lachezar uses evolutionary psychology to improve marketing and advertising, but also knows a lot about investing. So here we go!
Have you ever conidered investing? If you haven´t, you probably should. Most countries have pension models that are dependent on demographic change. Even welfare countries like Germany estimate that when its citizens take their pension, the amount that they´ll receive will be around 40% of the monthly income from their jobs. So there is a definite benefit to investing, to supplement this steep decrease in income. Yet, investing seems to be such a complicated topic. Asset allocation, bonds, stocks, funds, price-to-earnings ratios, making sure you avoid so-called bubbles. There is so much to know, that novices in the field could easily feel overwhelmed and intimidated. This is also coupled with the fear that you can lose all your money – every hard earned buck that you´ve ever made. And many have spent sleepless nights going over this fear again and again. So, the question arises – how do you invest so that you never go bust?
Nassim Taleb, author of Skin in the Game (from the Incerto series), suggests one possible solution: mental accounting. Before we even dive into this, though, we need to talk about probabilities. More precisely, we need to talk about the distinction between ensemble probability and time probability. Let´s imagine that 30 people go to a casino and play. If person 28 loses everything, can person 29 still play? Yes – that´s an ensemble probability. Now let´s imagine that one person goes to a casino with the intention to play for 30 days. If on day 28, he loses everything, can he play again on day 29? No – this is a time probability. Within different fields these probabilities are also known as independent and dependent. In a non-ergodic world, ensemble probability and time probability are not the same. Let´s look at another example. If you´d ride a motorcycle once, you´d most probably not going to die. But, if you´d ride a motorcycle regularly, this will most certainly decrease your life expectancy. Similarly, risk in investing is cumulative, due to repeated exposure over time – you cannot invest ever again once you are completely bust.
The remedy is mental accounting. Mental accounting is when you categorize (economic) resources, based on origin (e.g., money from salary, money from consulting/speaking engagements, money from rental real estate) and intended purposes (money for a car, money for university tuition). I´m sure that most of you are familiar with the concept already. Mental accounting is when you get your thirteenth salary (aka Christmas bonus) and decide to buy a new smartphone. It is when you get your tax refund and decide to book a weekend trip to Tenerife. You get the idea. In essence, your spending behavior changes, because you regard this “bonus” money as separate and different from what normally comes in every month. Mental accounting is traditionally considered an irrational behavioral, also known as bias. Yet, from an evolutionary perspective, mental accounting can reflect an adaptive feature, if one defines rationality as survival.
So how does mental accounting relates to investing? Let´s imagine that you have 1000 USD and your survival depends on you having the full amount of 1000 USD at all time. You feel adventurous on day 1 and you go long on an option (e.g., a S&P 500 index fund) with the full amount (I don´t recommend that you do this). Lucky for you, the government announces a stimulus package of $2 Trillion to liven up the economy. At the end of day 1, you are worth 1100 USD. You cash out (we’re ignoring trade and transaction costs here). What do you do on day 2? You create two mental accounts – survival (1000 USD) and risk capital (100 USD), and you never ever again touch the survival account. So, on day 2, you invest 30 USD in a highly risky option (e.g., Tesla stock) and at the end of the day you lose the 30 USD (Tesla goes bust). That´s ok. You didn´t go bust – you have your untouched survival account (1000 USD) and 70 USD in your risk capital account that you can invest in the subsequent days.
Some critics may say that it is irrational to view the 1000 USD in your one account as separate and different from the 100 USD in your other account (that you had at the beginning of day 2). The critics may point out that the 30 USD you lost at the end of day 2 was still “your” money. Hadn´t you decided to put the 30 USD in the market, you would have kept the amount and now be worth 1100 USD. The same critics may add that it is irrational to feel less psychological pain from your loss, because the lost money came from your “other” account. And they will be right. For themselves. That´s because they define rationality narrowly and post-hoc, disregarding the effects of repeated exposure over time and the importance of survival. But you – you have a different definition of rationality.
Rationality = Survival. Do whatever you want today, but make sure you´ll be here again tomorrow.