Even a CERTIFIED FINANCIAL PLANNER’s® (me) brain is wired to make money mistakes.
More often then I like to admit, as in daily, I’m making financial decisions that don’t make sense. You probably think someone that writes and talks about financial planning all day, could easily avoid these mistakes. However, it’s a little harder than that.
The purpose of this post is to define two different financial mistakes, that I and many others make daily, without even knowing.
# 1 – Mental Accounting
Definition: The tendency to value each dollar differently depending where it came from (tax refund, inheritance, salary, bonus, gambling winnings), where it’s kept (sub-savings accounts, PayPal, cash), and how it’s spent (term invented by economist, Richard Thaler).
Example of Mental Accounting: I inherited a small amount of Banco Popular (BPOP) stock, when my Grandpa passed away. At the time he passed, the stock was worth around $25. Today it’s worth $3.15. Even though it’s worth far less today, I can’t get myself to sell it. I know it’s the right thing to do because I don’t know much about the company. However, I still can’t sell it because I’ve accounted for it as “Grandpa’s stock.”
Another example is that I have a personal PayPal account, which is funded by anything I sell on eBay. I view and spend my eBay winnings differently than I spend my earnings from Gen Y Wealth. Rationally, I should value these dollars evenly, but I don’t. (Technically, I should even place a far higher value on my PayPal earnings because those are after-tax.)
Treatment: Filter all income, no matter the source and amount, into your primary savings account immediately. Once the money is in your savings account, calculate how many hours it would take you to earn that amount including taxes.
For example, you received a $1,000 tax refund and made $20 an hour this past year after taxes. That $20 tax refund is equivalent to working 50 hours.
Last, wait 30 days before you spend that money.
You can also use mental accounting to your advantage. When saving for goals, use sub-savings accounts. For example, I’m saving for a trip to Peru right now. In my ING Direct account, I have an account nicknamed Peru. I’ve mentally accounted for this money as money for travel. I couldn’t imagine spending it on anything else.
# 2: The Sunk Cost Fallacy
Definition: Sunk costs are expenses and resources, such as time, that can’t be recovered. The sunk cost fallacy is when you let previous sunk costs, weigh in on future decisions.
Example of the Sunk Cost Fallacy: Three months ago, you spent $2,000 fixing up your old car. It ran great for two weeks and then proceeded to break down again. This time it costs $3,000 for repairs.
Rationally, the $2,000 you put in previously, should not weigh into whether or not you should put $3,000 more into the car. That money is gone. Although, according to the sunk cost fallacy, you’re more likely to get the car repaired, knowing that you just spent $2,000 on it.
Another example is the stock I own in Banco Popular. It shouldn’t matter that the stock was worth $25. Right now an efficient market values that stock at $3.15. The money lost by not selling the stock is sunk. The sunk cost fallacy, tells me to hold on to that stock until I get my money back, which I’m guilty of.
Treatment: The easy answer is to not make decisions in the past, make them in the present. That’s easier said than done. So here is some tactical advice on how to accomplish that.
First, ask for help. If your car keeps breaking down, ask a friend or family member what they think. If three people tell you to junk the car, that’s probably the right decision.
For large financial decisions, pay a fee only CERTIFIED FINANCIAL PLANNER® for an hour of their time to review your choices. It’s a small cost to prevent large mistakes.
To avoid having the sunk cost fallacy affect your investments, don’t watch investment news and rarely check your portfolio. In order to have this hands off approach, you need to passively invest.
Personally I login to my investment accounts once a month. You can extend that if you like. I have known people who check once a year.
In the comments, explain a time when you fell victim to mental accounting or the sunk cost fallacy. Looking back, what would you do differently now?