Don't go too far with mental accounting

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#1
A good article which summarizes the Behavioural Finance trait of "Mental Accounting". Enjoy!

Happy Labour Day!

May 1, 2011
small change
Don't go too far with mental accounting

To insist on compartmentalising your money into separate accounts could hurt you financially
By Gabriel Chen, Finance Correspondent

I handle the funds in my POSB savings account with prudence and care. I want them to grow over time so I will have enough for my retirement, mortgage and other serious financial purposes.

I use my OCBC Bank savings account to buy and sell shares, treating the monies there more speculatively.

At first glance, this has the makings of sensible decision-making. It seems reasonable to clearly delineate between my safety capital and the money I can afford to lose. Also, earmarking money for my retirement needs may prevent me from spending it frivolously.

But in reality, any dividing line between a safe and speculative portfolio is nothing more than a misleading mental illusion. Despite all the work and time that I spend to separate my portfolios, my net wealth will be no different than if I had held one larger portfolio.

Here, I fall prey to a psychological heuristic known as mental accounting. This is the tendency for people to separate their money into separate accounts based on a variety of subjective criteria like the source of the money and intent for each account.

Behavioural economics pioneer Richard Thaler, who first coined the phenomenon, cites mental accounting when describing why it is so hard to find a cab on a rainy evening.

Cab drivers tend to knock off for the day after they reach a certain level of income - in other words, when they hit their mental income targets for the day.

Business is brisker on rainy evenings, so they will hit their mark quickly and knock off early. This in turn explains why there are noticeably fewer cabs on the street, according to Dr Thaler.

Mental accounting has enormous consequences in everyday life. It affects how people spend money and how they save; it influences how people deal with losses and windfall gains; and it determines how people think about finance and make financial decisions.

The advantage of this approach is that it enables people to evaluate their decision in isolation from other transactions, which then makes their assessment easier.

But if we are not careful, compartmentalising income and spending into different mental buckets can put us in a financial fix.

For example, some people have a special fund set aside for important purposes, such as a new home or their children's university education, while still carrying substantial credit card debt.

The logical thing would be to use the funds or any other available monies to pay off their debt. But these people are reluctant to do so because of the personal value they place on particular assets.

In this case, the mortgage or education fund is too important to relinquish, so they end up clinging on to the fund at the expense of their hefty debt.

Mental accounting explains why many shoppers eagerly snap up deals on items they do not need.

Seasoned shoppers often develop 'intuitive' notions of what this or that item should cost, and they typically stack it up against their expectations and biases.

When an item is at a substantial discount to what they are used to seeing, they sometimes buy it for that reason alone, just to feel they have snagged a good deal.

Another aspect of mental accounting is that people have a tendency to value money differently depending on where it comes from.

People are more likely to be impulsive or reckless with 'found' money such as work bonuses and lottery winnings.

For example, people who win $500 in the lottery - considered found money - are more likely to spend those takings on 'junk' than if they had earned that $500 on the job.

Partly due to mental accounting, it is also not uncommon to find some investment banks sending out memos during bonus time, reminding employees that those bonuses may be lower in subsequent years depending on market conditions and other external factors.

They encourage employees not to view bonus levels as a guarantee of minimum payment in future years, and particularly not to spend in anticipation of similar future bonuses.

For me, I try to avoid the mental accounting bias by reminding myself that money is fungible in that a dollar is a dollar, no matter where it came from, where it is located, or what I plan on buying with it.

While embracing this mindset is often desirable, it is not easy in practice, according to Barclays Wealth's head of behavioural finance Greg Davies.

Dr Davies suggests that people always strive to look at the big picture. 'Start with a review of your total wealth to understand this picture,' he tells me.

Next, as an extension of money being fungible, identify where you have financial assets earning less in interest than you are paying on loans. 'Then use the assets to pay down the loans,' he says.

gabrielc@sph.com.sg

My Value Investing Blog: http://sgmusicwhiz.blogspot.com/
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#2
Quite Enlightening. A reminder that we need to view all Assets equally.

A dollar in FD is no different from a dollar in stock nor a dollar in CPF. Maybe is time i do entire asset yearly returns and see how to control the variables/risks to meet Financial Freedom with all cylinders.


Cory

Just my Diary
corylogics.blogspot.com/


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#3
Mental accounting. I used to pay my home loan from my CPF-OA, even though I have enough cash to service the monthly mortgage. The logic was that "I cannot touch my CPF-OA anyway" and it was "better to have cash on hand rather than stuck in the illiquid property".

Recently I realised that the home loan was charged at 1.1-1.3% pa, while CPF-OA is giving 2.5-3.5% pa. I stopped my CPF payments, and immediately got 1.4% pa return by a few clicks of the mouse.

In fact, if I want to take this to an extreme, I can cash out a term loan on the equity in my house (effectively borrowing say, $100k) at 1.2% and deposit into my CPF for guaranteed 2.5% (3.5% for the first $20k). If the SIBOR or bank interest rate goes up, I will just use my CPF-OA to do capital repayment.

YMMV, this post is not a recommendation to act in any way.
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#4
(01-05-2011, 10:51 AM)corydorus Wrote: Quite Enlightening. A reminder that we need to view all Assets equally.

A dollar in FD is no different from a dollar in stock nor a dollar in CPF. Maybe is time i do entire asset yearly returns and see how to control the variables/risks to meet Financial Freedom with all cylinders.


Cory

"A dollar in FD is no different from a dollar in stock nor a dollar in CPF. "

Unquote:
Yes! But "asset allocation wise" will tell you there are a lot of difference when time is factored in. Don't have to say which $ will most probably gives you the best return in time.
WB:-

1) Rule # 1, do not lose money.
2) Rule # 2, refer to # 1.
3) Not until you can manage your emotions, you can manage your money.

Truism of Investments.
A) Buying a security is buying RISK not Return
B) You can control RISK (to a certain level, hopefully only.) But definitely not the outcome of the Return.

NB:-
My signature is meant for psychoing myself. No offence to anyone. i am trying not to lose money unnecessary anymore.
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#5
(22-10-2012, 01:52 PM)snowcap Wrote: Mental accounting. I used to pay my home loan from my CPF-OA, even though I have enough cash to service the monthly mortgage. The logic was that "I cannot touch my CPF-OA anyway" and it was "better to have cash on hand rather than stuck in the illiquid property".

Recently I realised that the home loan was charged at 1.1-1.3% pa, while CPF-OA is giving 2.5-3.5% pa. I stopped my CPF payments, and immediately got 1.4% pa return by a few clicks of the mouse.

In fact, if I want to take this to an extreme, I can cash out a term loan on the equity in my house (effectively borrowing say, $100k) at 1.2% and deposit into my CPF for guaranteed 2.5% (3.5% for the first $20k). If the SIBOR or bank interest rate goes up, I will just use my CPF-OA to do capital repayment.

YMMV, this post is not a recommendation to act in any way.

before u cash out a on a home equity loan and deposit into CPF..take note that whatever amt u put into CPF is subjected to the allocation rate to the respective OA,SA,MA just like the employeers CPF contribution....u deposit 100k into CPF it doesnt mean 100k goes to your OA...a portion of it will go to SA and MA too...bo hua since SA and MA u cant use to pay for your house...
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#6
(22-10-2012, 01:52 PM)snowcap Wrote: Mental accounting. I used to pay my home loan from my CPF-OA, even though I have enough cash to service the monthly mortgage. The logic was that "I cannot touch my CPF-OA anyway" and it was "better to have cash on hand rather than stuck in the illiquid property".

Recently I realised that the home loan was charged at 1.1-1.3% pa, while CPF-OA is giving 2.5-3.5% pa. I stopped my CPF payments, and immediately got 1.4% pa return by a few clicks of the mouse.

In fact, if I want to take this to an extreme, I can cash out a term loan on the equity in my house (effectively borrowing say, $100k) at 1.2% and deposit into my CPF for guaranteed 2.5% (3.5% for the first $20k). If the SIBOR or bank interest rate goes up, I will just use my CPF-OA to do capital repayment.

YMMV, this post is not a recommendation to act in any way.

Hi,

If i get you right, even if u have taken a bank loan for your property, you can still use your CPF to pay the bank loan.
Nothing to do with cash payment, right?

But if you are using cash payment, you may want to park your cash with singtel at 5% yield or STI ETF at 3.3% yield instead of earning 2.5% with CPF.

Did i miss out anything here?
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#7
(22-10-2012, 02:45 PM)toiletsiao Wrote: before u cash out a on a home equity loan and deposit into CPF..take note that whatever amt u put into CPF is subjected to the allocation rate to the respective OA,SA,MA just like the employeers CPF contribution....u deposit 100k into CPF it doesnt mean 100k goes to your OA...a portion of it will go to SA and MA too...bo hua since SA and MA u cant use to pay for your house...
oh, is that correct? I didn't know that.

(22-10-2012, 03:43 PM)camelking Wrote: Hi,

If i get you right, even if u have taken a bank loan for your property, you can still use your CPF to pay the bank loan.
Nothing to do with cash payment, right?

But if you are using cash payment, you may want to park your cash with singtel at 5% yield or STI ETF at 3.3% yield instead of earning 2.5% with CPF.

Did i miss out anything here?
Let me illustrate. I take a bank loan for $xxx,000. Say the interest rate is 1.2%. Say the monthly payment is $1,000. I can pay this $1,000 from my CPF-OA, or I can pay it with cash, or I can use a combination of CPF-OA and cash.

If I use CPF-OA, I am using money that can earn 2.5% to pay off a loan that charges 1.2%. Not very smart right? Over one year, I will use $12,000. This $12,000 left in CPF-OA could have earned me 0.025x12,000 = $300, which I am not entitled to now. The mortgage that I paid off will reduce my interest by 0.012x12,000=$144.

Let's say I have $12,000 cash sitting idle in my savings account. In 1 year it will earn me 0.01% or $12 interest. Now let's say I use the $12k cash to pay the housing loan. Effectively I am using 0.01% money to trade for 2.5% money. My opportunity cost is the $12, and my gain is the $300 in CPF-OA interest.

Of course the clever people in this forum will then say, "Why use your cash to pay housing loan? Invest in undervalued companies or dividend stocks and make 6-15% (or more). Why bother with the 2.5%?" My reply will be that CPF's 2.5% is guaranteed (barring war or sovereign disaster, in which case this discussion becomes largely irrelevant). It's a question of risk appetite, really. Actually, now that you mention it, how much "safer" is CPF than Singtel, that it warrants a lower yield? I don't know.

This process applies only if you have "spare cash". I would appreciate comments from members. Thanks!
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#8
(22-10-2012, 07:50 PM)snowcap Wrote:
(22-10-2012, 02:45 PM)toiletsiao Wrote: before u cash out a on a home equity loan and deposit into CPF..take note that whatever amt u put into CPF is subjected to the allocation rate to the respective OA,SA,MA just like the employeers CPF contribution....u deposit 100k into CPF it doesnt mean 100k goes to your OA...a portion of it will go to SA and MA too...bo hua since SA and MA u cant use to pay for your house...
oh, is that correct? I didn't know that.

yup .... I am in a similar situation like u..i was thinking of the same.. lol

this is extracted from the cpf website regarding voluntary contribution

"Making voluntary contributions
For employees:
You may wish to make voluntary CPF contributions to build up your retirement savings. These contributions will be credited into your CPF Ordinary, Special and Medisave accounts according to the percentage allocated for your age and can be used for your housing and healthcare needs. You can make a one-time payment, or regular contributions deducted by GIRO to your CPF accounts."
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#9
Makes sense except for 1 thing: liquidity. You can't even get everything out at 62. How much would you pay for liquidity?

CPF money is stuck and can only have limited uses, one of which is housing. So you earn 2.5% in CPF OA and instead use spare cash to pay the installments... you are basically saying your cost of liquidity is 2.5%

Put in another way, blue chip stocks (I define as those that are unlikely to die) like Singtel and DBS is paying 5-4% pretty stable. In 20 to 30 years' time do you think the share price will be lower than now ie capital loss?

IMHO your strategy make sense if the spare cash is part of your asset allocation used to buy fixed income instrument for retirement anyway. From this perspective you can even consider putting the money into SA instead to get 4% (for now) and tax shield at the same time.
Before you speak, listen. Before you write, think. Before you spend, earn. Before you invest, investigate. Before you criticize, wait. Before you pray, forgive. Before you quit, try. Before you retire, save. Before you die, give. –William A. Ward

Think Asset-Business-Structure (ABS)
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#10
Other mental accounting illusions:

1) Paper loss is not a real loss until you realised it...

2) I don't count the home I live in as part of my net wealth...

If I am a gold digger, I would know who to choose: A guy with 20 million landed property with "only" 500 thousand cash versus a guy with 2 million cash but stays in a HDB flat - money is money in whatever form: http://singaporemanofleisure.blogspot.sg...water.html
Just google singapore man of leisure
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