Have you spent your $10,000 government handout yet?  If yes, perhaps you bought a new phone? If not, are you saving it for a trip, or looking to invest in compound interest? I believe that all of us will be very care-free with this $10,000 because it is almost "Free Money". As a result, it is not surprising that most of us will lavishly spend this money due to an economic phenomenon known as "Mental Accounting" in behavioral finance.

 

Mental accounting was proposed by Richard Thaler, a Nobel laureate in Economics. He pointed out that we unconsciously plan and manage our wealth into different mental accounts. For example, we tend to place our salaries under the "Labor" account, investment income in the "Speculation" account, and money from winning the lottery in the "Free Money" account.

 

 

We are careful and frugal with the money in our "Labour" account; we are more relaxed with the money in our "Speculation" account; and we seldom cherish the money in our "Free Money" account, which appears to always come to us easily.

 

However, this is a misconception. No matter if the $10,000 comes from work, as investment returns or a lottery prize, it makes no difference in monetary value. But our mind believes that there are differences between these moneys due to “mental accounting”.

 

How does "Mental accounting" affect our spending behavior? 

 

Here's a real life example. Imagine you were going to buy a lunch that costs HK$100. While you are waiting in the queue, one of the following things occurs: 1) You realize that you've lost HK$100; 2) You buy the lunch, but after having one bite, you fall and your lunch ends up on the floor. In both senarios (given that you still have enough money), would you still buy another lunch?

Logically speaking, your answer should be the same for both cases. Yet, given the "mental accounting" effect, most people will not buy another lunch in the second scenario as they feel that money has already been spent. In the first scenario however, most people will buy another lunch as they do not consider the lost money as part of their lunch budget.

 

Mental accounting and investment

 

 

The mental accounting bias also affects investing. For instance, some investors prefer to have a safe portfolio and a speculative portfolio to avoid negative returns. Despite the time and efforts spent in maintaining 2 separate portfolios, the combined net worth of these two portfolios is actually the same as having one large portfolio with different investment products.

 

3 Mental Accounts

 

Although we should avoid mental accounting bias as much as possible, a suggested way to reduce its effect on your decision-making is to have three broad accounts in your book.

1. Essential expense Account

2. Non-essential expense accounts

3. Savings and Investment Account

 

Use the 50/30/20 rule to allocate money into these accounts.

 

Put 50% of your income into essential expenses such as rent, food, transportation, and loans. If you still can't cover your essential expenses with 50% of your income, you may want to consider lowering your quality of life or finding ways to increase your income.

 

30% of your income goes to non-essential expenses such as shopping, travel, and other leisurely activities. It’s hard to draw a clear line between essential and non-essential expenses. Whenever you pay for anything, ask yourself, "Would I be unable to live without it?” If you can, consider putting it down. Of course, it's totally fine to reward yourself as long as you can afford it.

 

Put 20% of your money into a savings or investment account, which can be used for a rainy day or invested to bring sizable income. If you plan to invest, it’s recommended to save an emergency reserve, as investments always involve risk. An emergency reserve usually covers 3 to 6 months of daily expenses.

 

If you are new to investing and lack investment experience,  why not consider AQUMON, a fully automated, 100% systematic, 7/24 monitoring, high transparency robo advisor!

 

 

 

 

 

About us

As a leading startup in the FinTech space, AQUMON aims to make sophisticated investment advice cost-effective, transparent and accessible to both institutional and retail markets, via the adoptions of scalable technology platforms and automated investment algorithms.

AQUMON’s parent company Magnum Research Limited is licensed with Type 1, 4 and 9 under the Securities and Futures Commission of Hong Kong. In 2017, AQUMON became the first independent Robo Advisor to be accredited by the SFC.

AQUMON’s investors include Alibaba Entrepreneurs Fund, Bank of China International and HKUST.

 

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