Clouded by mental maths

A recent discussion with an elderly couple on the state of their finances in retirement was something that I was least looking forward to as part of a weekend chore. But, to maintain familial harmony, I braved myself up to what opened my eyes to the ways in which senior citizens manage their monies. Having recently retired, they were trying to get an assessment on managing their retired life with their savings. While nothing was bad with their finances, the way they were using their savings was just inefficient.

The discussion veered towards several insurance policies and annuities they had compared to just a few investments they had. However, they were happy with their policies as they were structured to pay them a monthly income. It is a different issue that on analysis I was able to demonstrate what little they were getting from these policies. Strangely, they did not seem to mind it, even when it was tax inefficient. This set me thinking on their behaviour and the answer was more to do with the mental maths they had applied to feel happy with the monthly income.

Mental accounting is the brainchild of Richard Thaler, who has detailed a lot about this aspect in his book, ‘Misbehaving: The making of behavioral economics’. The anecdotes on the way people behave with their money are beautifully stated in the numerous experiments and its outcomes discussed in the book. Roughly, mental accounting suggests that people segregate money between different ‘accounts’ and that they then apply different sets of rules to these accounts. This can lead to all sorts of peculiar behaviour in investing. Coming back to the couple I met, they had not earmarked any account, which meant, for them as long as the money came, it could go anywhere to meet their needs of the day. To them, money was perfectly fungible, as also mentioned by Thaler. After all, it is this fungible aspect of money that makes mental accounting feasible.

However, the same fungible principle is not applied when it comes to saving or investing money. For instance, saving in a bank recurring deposit over the next 3-5 years is no different from starting an SIP for the same period for the same sum. But, chances are there will be more people willing to opt for the RD over the SIP.

The mental math bias makes an FD or RD far more attractive for the fixed returns it offers, without realising its tax inefficiency and lack of liquidity over a mutual fund, which does not guarantee returns. Don’t be clouded by your inability to visualise a return that seems complex when investing. The lessons learnt by mutual fund companies in recent times from this aspect of behavioural finance is that most of their communications are now focused on the goals that one can achieve by investing in them, which can help people visualise the benefits better.

Our cover story is on this aspect and addresses the need for investing with goals as objectives rather than invest in the best funds, something that I managed to get the elderly couple to also work towards.

olmdesk@outlookindia.com