The next time you visit your grandmother’s house, notice how she manages her household expenses. She will most likely have money stuffed in various jars, with each jar representing a particular type of expense.
One jar may be labelled ‘groceries’, while another may be earmarked for pampering the grandchildren. In this article, we discuss the psychology behind such behaviour. We then show how to apply this to managing your core portfolio.
Mental accounting
Your grandmother’s cookie jar approach to managing expenses underscores an important point; total monthly expenses are not considered as a whole, but sum of parts. Typically, this cash is not fungible. That is, if the entertainment jar runs out of money, your grandmother is unlikely to transfer cash from the grocery jar.
Richard Thaler, a well-known behavioural economist, calls this behaviour “mental accounting”.
His research found that students were unwilling to buy another movie ticket when they lost a ticket worth, say, ₹500. However, the same students were willing to buy a ticket when they lost ₹500 in cash! Such behaviour is intriguing.
After all, losing ₹500 should have the same effect on an individual, whether it is in the form of ticket or cash. Yet, that was not the case. Why? Thaler reasoned that the students “mentally” debited the entertainment account when they bought the ticket. They were, hence, unwilling to debit the same account with another ₹500 and buy another ticket. In the other case, money in the purse was not debited to any account yet. So, Thaler reasoned that the students were willing to buy the ticket when they lost the money.
Your grandmother’s approach to managing expenses is similar, except that she uses cookie jars. Modern day cookie jar approach includes using envelopes earmarked for specific expenses.
This approach is useful because it helps in managing your expenses well. You typically spend within your budget or as long as there is money inside the envelope. And it works well for routine expenses such as transportation, monthly entertainment, groceries and other utilities.
Bucketing approach
We now extend the concept of ‘mental accounting’ to your investing decisions.
Our discussion is based on the core-satellite portfolio framework, where the core portfolio represents goal-based investments and the satellite portfolio is set up to capture gains from short-term movement in the financial markets. Now, instead of creating one single master portfolio to achieve your goals, consider each life goal as a “mental account” or a cookie jar. Why?
Creating separate portfolios for each goal helps you buy investment products that are appropriate to meet the goal. For example, your highest-priority goal would be to meet your child’s education costs 10 years hence. Highest-priority goal essentially has low tolerance to failure. Therefore, the risk you will be willing to take for this goal will be much less than that you would assume for your retirement goal. So, “Education for Children Account” will have more bond investments than your retirement account.
The above form of investing is referred as the ‘bucketing’ approach, where each ‘bucket’ (equivalent to a ‘mental account’) represents a life goal. Each goal-based portfolio will have two asset classes.
Your equity investments will be in equity mutual funds set-up through SIPs. Your bond investments will be in bank recurring deposits with maturity equal to the time horizon of your life goal. Period.
The writer is the founder of Navera Consulting.
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