Use mental accounts to create your investment portfolios

Last week, we discussed the relevance of diversified portfolios. We argued that you would do well to spend your time in setting up a methodical savings-investment process instead of seeking products to create a diversified portfolio! This week, we continue with the diversification theme. Specifically, we discuss why portfolios you create in the real world do not follow the rules of diversification and yet may help you reach your investment objectives.

Family needs

If you are typical individual, your first concern would be to protect your family’s basic standard of living. You should, therefore, buy life insurance and medical insurance and simultaneously set up an emergency fund.

Then, you should take steps to create your investment objectives such as meeting your child’s college tuition and your retirement needs.

Now, it is easier to focus on a goal if you set up a separate portfolio to meet each investment objective. This argument comes from the way we think about expenses, a process that behavioural psychologists call as mental accounting. The rule of mental accounts is simple. Each month, you allocate money to each expense account. You may, for instance, decide to spend Rs 10,000 a month on groceries and Rs 2,500 a month on fine dining. If you have exhausted the money allocated to grocery, you do not take money from your fine dining or entertainment account to meet your grocery expenses. This rule goes against the logic that money is fungible.

Mental accounting is useful because it helps in controlling our expenses. The basic rule that one expense account is not fungible with the other moderates your urge to overspend and helps you stay focused on living within your “mental” budgets. You can use the same logic to create your investment portfolios. After all, you invest to accumulate wealth to meet your future consumption needs.

Portfolio buckets

To create portfolios based on mental accounting, you should prioritise your investment objectives and then create a separate portfolio to meet each investment objective.

This process of setting up target portfolios is called portfolio bucketing; visualise each objective as a bucket into which you put money to accumulate wealth.

While the concept of mental accounting is based on the rule that money is not fungible, you may decide to transfer money from one target portfolio to the other. This fungibility process should be hierarchical.

That is, you should only transfer money from a low priority portfolio to a high priority portfolio and not the other way. Suppose you have three target portfolios — education, retirement and housing in the same order of priority.

You can transfer money from the housing portfolio to the education portfolio and not the other way, even if the housing portfolio has a shorter investment horizon. You can extend the logic of mental accounting to a process called time segmentation. In this approach, you create portfolios based on your investment horizon.

You can, for instance, create three time buckets during your working life. This could be goals you want to achieve with investment horizon of not more than 5 years, between 6 and 15 years and more than 15 years. Your mental account will then be based on time, where individual objectives falling within 5 years will be gathered into one time bucket.

Assessing risk

The idea of creating separate portfolios goes against the concept of diversification. Why? When you buy an equity fund for your retirement portfolio, you are expected to evaluate the merits of investing in the fund as well assess how much risk the fund will add to your total portfolio.

But each target portfolio is created separately, without regard to its risk relationship with other portfolios.

Portfolio bucketing may, thus, seem an inefficient process, but can be effective from a behavioural perspective because it is based on mental accounts.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. Feedback may be sent to knowledge@thehindu.co.in)

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